A framework for loss given default validation of retail portfolios

Stefan Hlawatsch and Peter Reichling

Abstract

ABSTRACT

Modeling and estimating loss given default (LGD) is necessary for banks that apply for the internal ratings based approach for retail portfolios. To validate LGD estimations, there are only a few approaches discussed in the literature. In this paper, two models for validating relative LGD and absolute losses are developed. The validation of relative LGD is important for risk-adjusted credit pricing and interest rate calculations. The validation of absolute losses is important to meet the capital requirements of Basel II. Both models are tested with real data from a bank. Estimations are tested for robustness with in-sample and out-of-sample tests.