# Loss Given Default (LGD): Two Ways to Calculate, Plus an Example

![Loss Given Default (LGD): The estimated amount of money a financial institution loses when a borrower defaults on a loan.](https://www.investopedia.com/thmb/M-8K9CpYG8z_2gPY8tzsXzDCewE=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/lossgivendefault-final-89172b8d462e4fa69dbcc4a59f60b0a7.png)

*LGD is expressed as a percentage of the total loan amount. — Investopedia / Lara Antal*

> **Definition**
>
> Loss given default refers to the estimated credit loss that results if a borrower defaults on their financial obligation.

## What Is Loss Given Default?

Loss given default (LGD) is the amount of money that a [bank](https://www.investopedia.com/the-best-online-banks-11722209) or other financial institution is projected to lose when a borrower [defaults](https://www.investopedia.com/terms/d/default2.asp) on a loan.

LGD can be shown as a percentage of total exposure at the time of default or as a single dollar value of potential loss.

A financial institution’s total LGD is calculated after a review of all outstanding loans using cumulative losses and exposure.

### Key Takeaways

*   The LGD is an important calculation for financial institutions, projecting their expected losses due to loan defaults.
*   The expected loss of a given loan is calculated as the LGD multiplied by the probability of default and the exposure at default.
*   Exposure at default is the total value of the loan at the time a borrower defaults.
*   An important figure for any financial institution is the cumulative amount of expected losses on all outstanding loans.
*   LGD is an essential component of the Basel Model (Basel II), a set of international banking regulations.

## Understanding LGD

Banks and other financial institutions determine credit losses by analyzing actual [loan](https://www.investopedia.com/the-best-personal-loans-for-fair-credit-8764836) defaults.

Quantifying losses can be complex and require an analysis of several variables. How credit losses are accounted for on a company’s financial statements includes determining both an [allowance for credit losses](https://www.investopedia.com/terms/a/allowance-for-credit-losses.asp) and an [allowance for doubtful accounts](https://www.investopedia.com/terms/a/allowancefordoubtfulaccounts.asp).

Consider if Bank A lends $2 million to Company XYZ and the company defaults. Bank A’s loss is not necessarily $2 million.

Other factors must be considered, such as the amount of collateral, whether installment payments have been made, and whether the bank makes use of the court system for reparations from Company XYZ.

With these and other factors considered, Bank A may, in reality, have sustained a far smaller loss than the initial $2 million loan. Determining the amount of loss is an important and fairly common parameter [in most risk models](https://www.investopedia.com/ask/answers/022415/what-factors-are-taken-account-quantify-credit-risk.asp).

### The Basel Model

LGD is an essential component of the Basel Model ([Basel II](https://www.investopedia.com/terms/b/baselii.asp)), a set of international banking regulations. It is used in the calculation of [economic capital](https://www.investopedia.com/terms/e/economic-capital.asp), expected loss, and regulatory capital.

The expected loss is calculated as a loan’s LGD multiplied by both its [probability of default (PD)](https://www.investopedia.com/terms/d/defaultprobability.asp) and the financial institution’s [exposure at default (EAD)](https://www.investopedia.com/terms/e/exposure_at_default.asp).

> **Important**
>
> Loans with collateral, known as secured debt, greatly benefit the lender and can benefit the borrower through lower interest rates.

## How to Calculate LGD

There are different ways to calculate LGD.

1\. A common variation considers the exposure at default and recovery rate. Exposure at default is an estimated value that predicts the amount of loss a bank or [credit union](https://www.investopedia.com/the-best-credit-unions-8783335) may experience when a debtor defaults on a loan.

The recovery rate is a risk-adjusted measure to right-size the default based on the likelihood of the outcome.

**LGD (in dollars) = Exposure at Default (EAD) x (1 - Recovery Rate)**

2\. Another basic variation compares the potential net collectible proceeds to the outstanding debt. This formula provides a general ratio of what portion of debt is expected to be lost:

**LGD (as a percentage) = 1 - (Potential Sale Proceeds / Outstanding Debt)**

Of these two methods, it is more common to see the first formula used as it is a more conservative approach to reflect the maximum potential loss.

It can often be difficult to assess what the potential sale proceeds are, especially considering multiple collateral assets, disposition costs, timing of payments, and liquidity of each asset.

## LGD vs. EAD

Exposure at default is the total value of a loan that a [bank](https://www.investopedia.com/articles/personal-finance/111815/6-biggest-banks-offering-personal-loans.asp) is exposed to at the time that a borrower defaults.

For example, if a borrower takes out a loan for $100,000 and two years later, the amount left on the loan is $75,000. The borrower defaults. The EAD is $75,000.

When analyzing [default risk](https://www.investopedia.com/terms/d/defaultrisk.asp), banks will often calculate the EAD on a [loan](https://www.investopedia.com/emergency-loans-for-bad-credit-5075539) as it aims to predict the amount the bank will be exposed to when a borrower defaults. EAD constantly changes as a borrower pays down their loan.

The main difference between LGD and EAD is that LGD takes into consideration any financial amount recovered on the default. For this reason, EAD represents a more conservative measurement since it is the higher figure. LGD is more often the best case scenario that relies on multiple assumptions.

For example, if a borrower defaults on their [car loan](https://www.investopedia.com/auto-loans-4689734), the EAD represents the remaining loan amount in default. If the [bank](https://www.investopedia.com/the-best-car-loans-for-bad-credit-11724154) repossesses the car and sells it to recover a portion of the EAD, the recovered amount gets factored into the LGD calculation.

> **Tip**
>
> Depending on the loan, such as a mortgage or student loan, a different number of days passed without payment counts as a default. Make sure you are aware of the figure for your specific loan.

## Example of LGD

Imagine that a borrower takes out a $400,000 loan for a condo. After making installment payments on the [loan](https://www.investopedia.com/the-best-mortgage-lenders-for-bad-credit-11697459) for a few years, the borrower experiences financial difficulties.

It is estimated that the borrower has an 80% chance of default, which means the recovery rate is 20%. The outstanding loan balance is $300,000, and the [bank](https://www.investopedia.com/banks-credit-unions-best-for-personal-loan-7570430) will be able to sell the condo for $200,000 upon foreclosure.

To calculate the LGD in dollars, compare the amount at risk to the likelihood of default. Using the first formula above, the lender finds that $240,000 is at risk of default.

**LGD (in dollars omitting collateral) = $300,000 x (1 - 0.20) = $240,000**

Alternatively, LGD can be calculated as a percentage that typically incorporates the value of the collateral.

Although the first formula is easier to calculate, it does not factor in the [disposition](https://www.investopedia.com/terms/d/disposition.asp) proceeds of the condo in the event of default.

So, using the second formula above, when considering the collateral value the lender should anticipate losing 33% of its capital should the condo owner default_._

**LGD (as percentage including collateral) = 1 - ($200,000 / $300,000) = 33.33%**  

## What Does Loss Given Default Mean?

Loss given default (LGD) is the amount of money that a financial institution loses when a borrower defaults on a [loan](https://www.investopedia.com/the-best-credit-builder-loans-8764460), after considering any recovery, represented as a percentage of total exposure at the time of loss.

## What Are PD and LGD?

LGD stands for loss given default and refers to the amount of money a bank loses when a borrower defaults on a [loan](https://www.investopedia.com/the-best-personal-loans-for-debt-consolidation-8762444). PD stands for the probability of default, which measures the probability that a borrower will default on their loan.

## Can Loss Given Default Be Zero?

Loss given default can theoretically be zero when a financial institution models LGD. If the model shows that a full recovery of the [loan](https://www.investopedia.com/the-best-loans-for-low-income-11697420) is possible, then the LGD can be zero. However, a zero LGD is usually rare.

## What Is Usage Given Default?

Usage given default is another term for exposure at default, which is the total value left on a [loan](https://www.investopedia.com/the-best-personal-loans-with-a-cosigner-8763086) when the borrower defaults.

## The Bottom Line

When making loans, banks tend to reduce their risk as much as they can. They evaluate a borrower and determine the risk factors of [lending](https://www.investopedia.com/the-best-va-loan-lenders-11697437) to that borrower, including the probability that they will default on the loan and how much the bank stands to lose if default occurs.

Loss given default (LGD), probability of default (PD), and exposure at default (EAD) are calculations that help banks quantify their potential losses.

> **Article Sources**
>
> 1.  Bank for International Settlements. “[Basel II: Revised International Capital Framework](https://www.bis.org/publ/bcbsca.htm).”
>     
> 2.  Consumer Financial Protection Bureau. “[Differentiating Between Secured and Unsecured Loans](https://files.consumerfinance.gov/f/documents/cfpb_building_block_activities_differentiating-secured-unsecured-loans_guide.pdf),” Page 3.