The Impact Of Systemic Loss Given Default On Economic Capital

Jenni Van Dyk, Jaun Lange, Gary Van Vuuren
2017 International Business & Economics Research Journal  
Empirical studies have demonstrated that loan default probabilities (PD) and loss given defaults (LGD) are positively correlated because of a common, business cycle, dependency. Regulatory capital requirements demand that banks use downturn LGD estimates because the correlation between PD and LGD is not captured. Economic capital models are not bound by this constraint. We extend and implement a model which captures the PD and LGD correlation by exploring the link between defaults and
more » ... aults and recoveries from a systemic point of view. We investigate the impact of correlated defaults and resultant loss rates on a portfolio comprising default-sensitive financial instruments. We demonstrate that the systemic component of recovery risk (driven by macroeconomic conditions) exerts greater influence on loss estimation and fair risk pricing than its standalone component.
doi:10.19030/iber.v16i2.9884 fatcat:f2qhavtxz5bw7mybn25jggvcg4