In order to maintain their capital and perform their operations almost all the companies borrow loan from banks and other companies. Most of the companies return the borrowed loan however this is not always the case as sometimes the companies or the businesses default on borrowed loans as they are unable to return the loan. Such a situation where a company is not able to return loan and default on the borrowed is called Loss Given Default Situation. There are a number of methods of calculating loan given default however the most common method is that where total loss is compared with the total potential exposure when the default occurs. Banks and other lending institution don’t calculate LGD on individual loans instead they calculate the cumulative loss occurred due to the LGD on given accounts where borrowers are unable to return loan.
LGD results in the credit loss of the banks and they need to calculate their actual loss that occurred in a given financial period due to LGDs. In most of the cases a number different variables are associated with loss given default calculation and it is sometimes difficult to calculate. For example a company XYZ borrowed a loan of 1 million dollars from a bank ABC. Now the company is unable to pay back the borrowed amount and defaults on the note. In an aerial view we can think that the loss incurred by the bank is 1 million dollar however this may not be the case as the bank may hold physical assets of the company as a collateral in return to loan. So the total loss of the bank will be the loan amount minus the market value of the asset hold as collateral.
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