Climate-related loss given default

Sergio Scandizzo and Tony Hughes

INTRODUCTION

Loss given default (LGD) is defined as a percentage of the exposure at default (EAD) (Basel Committee on Banking Supervision, 2006). According to Peter (2011), economic loss may be characterised as the change in the value of a facility resulting from a default and, consequently, the computation of LGD can be expressed as:

$${\text{LGD} }_j\left( t_{DF }\right)=\frac{{\text{EAD} }_j\left( t_{DF }\right)-\text{NPV}\left( {\text{Rec} }_j(t),t\ge t_{DF }\right)+\text{NPV}\left( {\text{Costs} }_j,t\ge t_{DF }\right) }{{\text{EAD} }_j\left( t_{DF }\right) }$$

Here, NPV refers to net present value, t_DF is the time of default and Rec_j(t) and Costs_j(t) represent recoveries and costs observed at time t. This formula can be directly computed from complete data including information on all incurred losses. However, in cases of incomplete information, especially when the facility has not defaulted or is undergoing workout, LGD becomes a random variable and necessitates estimation, as highlighted by Bennet, Catarineu and Moral (2005).

As for other risk parameters, climate risk can affect LGD in two ways: through physical risk, which is the direct damage caused by extreme weather events or gradual changes in climate, and through transition risk, which is the indirect impact of policy, that is, legal, technological or market