Measuring LGD on Commercial Loans: An 18-Year Internal Study

parameters in a bank’s risk-rating system that impact facility ratings, approval levels, and the setting of loss reserves, as well as developing credit capital underlying risk and profitability calculations. LGD can be measured as either the net charge-off rate (accounting LGD), or the present value of cash losses (economic LGD), with respect to the initial book value of a defaulted obligation. Analysis of JPMC’s loss history entailed compilation of quarter-end book balances, charge-offs, recoveries of chargeoffs, and cash flows for all customers that defaulted in the period 1982-99, with losses determined through 2002. LGD was computed for JPMC as a whole and was differentiated by business unit, industry group, geographic region, cohort year, and collateral type. Some findings of the study are as follows: • Overall, the average accounting and economic LGD was found to be 27.0% and 39.8%, respectively. An annual discount rate of 15% was used to compute the economic LGD. • Differentiation by business unit revealed that while the JPMC Investment Bank (IB) unit’s borrowers had an economic LGD of 40.4%, the Middle Market (MM) and Private Bank (PBG) organizations’ borrowers had lower economic LGDs of 38.7% and 34.5%, respectively. • The distribution of LGD was seen to be bimodal, with large concentrations at 0% and 100% and with a high standard deviation (on the order of the mean). • Economic LGD was found to be lower for secured (40.9%) as compared to unsecured facilities (50.5%) for a large subset of the population. • The average time to final resolution and the average time a loan remained in a nonaccrual status were computed to be 2.4 years and 1.8 years, respectively, again with significant variability. • Results by industry and geographic region showed wide variation in LGDs but were deemed not statistically sig-