To my understanding, only retail exposures secured by residential properties will be subjected to a 10% LGD floor by the new Accord (ref. 266). While most other credit exposures may be bound to a risk weight or capital floor imposed by local supervisor, it will be based at their own discretion. However, not many supervisors have came up with the idea of floor yet, therefore none of the banks that we have come across have specifically imposed a floor to their LGD or risk weight calculation.
Note that the LGD floor of 10% of residential mortgage is to be applied at the pool level, not individual facility level.
It is in fact possible to have an unstressed LGD of 0% or even negative LGD value in certain asset classes, such as commercial leasing, where the bank may profit from the sale of an recovered asset (in extreme circumstances). Having said that, this doesn’t occur very often. However once you stress the LGD to an economic downturn LGD, it is rare that LGD will still be 0% particularly if you include intangibles, cost items such as cost of recoveries and the time value of money which cannot be recovered (even if the exposure is secured by 100% collateral value).
As a result LGD cannot be 0% because of the internal cost and economic value, however they can be very close to zero if there is evidence to support this (such as mortgage insured exposures).
However due to paragraph 266, residential mortgage exposures will be subjected to 10% LGD floor for the purpose of capital requirements even if it is mortgage insured.
As for other assets, there is no incentive for banks to imposed a LGD floor for internal assessment, however they are subject to a floor for capital requirements (based on supervisory discretion and therefore outside of the bank’s control).
I recommend that banks impose a floor of 0% on their LGD to:
- cater in extreme scenario where a bank does make a profit in the event of a recovery transaction;
- allow for irregular data error; and
- add a margin of conservatism (given the fact that banks may make money out from a default transaction).
There is no incentive for Banks to impose a LGD floor apart from the Accord requirement.
- Should bank imposed a LGD floor for each of their asset classes?
- Should bank assigned 0% LGD for mortgage-insured or over-collaterised assets?