Loan for Business

Loss Given Default (LGD): Meaning, Formula, and Significance in Credit Risk

By Tata Capital
06 January 2026
8 mins read
3119

When a borrower fails to repay a loan, it results in a loss for the lender. To manage and prepare for such risks, financial institutions rely on a metric called Loss Given Default. It refers to the portion of a loan that a lender stands to lose if the borrower defaults, after accounting for any recoveries. This measure is a key part of credit risk management and helps lenders estimate potential losses, decide loan terms, and set aside reserves accordingly. In this article, we explain what is LGD, why it matters in lending, and how it is calculated in practice.

What is Loss Given Default (LGD) in Finance?

In simple terms, Loss Given Default, or LGD in finance, is the estimated amount of money that a financial institution can lose if the borrower fails to pay back the loan amount. The LGD of a loan can be expressed as a percentage or as a numerical value of the total sum exposure at the time of default.

Calculating the Loss Given Default of a loan is a critical component in the overall credit risk calculation. With this, a lender is able to sanction only those loans whose risks are well within its loss appetite.

Moreover, the LGD model credit risk is not a static value. It varies depending on the collateral, seniority of debt, and the prevalent market conditions. For instance, the LGD percentage of a defaulted loan is usually lower when it is secured with collateral. This is because a good chunk of the default amount can be recovered by liquidating those assets.

Also, read – Understanding Legal Consequences on Education Loan Defaulter

Why Is Loss Given Default Important?

The Loss Given Default model has significant importance for the following reasons:

Risk Management: LGD calculation helps the lender quantify the potential loss in case of any loan default. This allows financial institutions to make an informed decision about approving loans to an entity.
Pricing: Through proper assessment of the risk associated with a particular loan, the lender can come up with a better pricing strategy. With this, they can charge an interest rate that is commensurate with the risk.
Regulatory Compliance: The Basel II regulatory framework mandates prior LGD calculation to ensure that banks maintain appropriate risk management strategies and capital buffers against credit risk.
Portfolio Optimisation: With the help of LGD, banks can optimise their credit portfolios by properly managing their high and low-risk credits.

How to Calculate Loss Given Default

There are multiple ways to calculate the Loss Given Default of a particular credit case. However, we will be focusing on two widely used Loss Given Default formulas.

Formula 1:

LGD = Exposure at Risk (EAD) * (1 – Recovery Rate)

This loss given default formula uses two factors: exposure at risk and the recovery rate. Exposure at default estimates the loss a bank or credit union may face if a borrower defaults on a loan. The recovery rate helps adjust the loss based on how much of the defaulted amount is likely to be recovered.

Formula 2:

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

This method compares the expected proceeds from selling assets to the outstanding debt. It provides an estimate of the portion of debt that is likely to be lost based on potential sale proceeds.

Of the two methods, the first is more commonly used because it gives a more conservative estimate of the maximum possible loss. The second method can be harder to apply, as it’s difficult to estimate sale proceeds due to factors like multiple assets, selling costs, payment timing, and asset liquidity.

Example Scenario

X Bank provided a loan of Rs. 50,00,000 to “Star Innovations,” a tech startup, with company assets as collateral. After two years of on-time payments, the startup defaults due to market challenges. The probability of default is 60%, meaning the recovery rate is 40%. The outstanding loan is Rs. 30,00,000, with Rs. 15,00,000 recoverable from liquidating assets.

To calculate the numerical LGD:

LGD = Exposure at Default (EAD) × (1 – Recovery Rate)

LGD = 30,00,000 × (1 – 0.4) = 30,00,000 × 0.6 = Rs. 18,00,000

To calculate the percentage LGD:

LGD = [1 – (Sale Proceeds / Outstanding Loan)] × 100%

LGD = [1 – (15,00,000 / 30,00,000)] × 100% = 50%

Thus, the LGD is Rs. 18,00,000 or 50%, indicating that the lender is likely to lose half of the outstanding loan amount.

Also, read – Get Urgent Loan for CIBIL Defaulters

Key Factors Influencing Loss Given Default (LGD)

Loss Given Default (LGD) shows how much money a lender may lose if a borrower fails to repay a loan. Several factors decide whether the loss is small or large.

1.Collateral Quality and Liquidity

Collateral works as a backup for lenders. Assets that hold value and can be sold quickly, like well-located property, help lenders recover money faster. In contrast, assets that are outdated or hard to sell, such as specialised machinery, often lead to higher losses. The easier it is to convert collateral into cash, the lower the LGD.

2. Loan-to-Value (LTV) Ratio

LTV compares the loan amount to the value of the collateral. A lower LTV means the collateral value is much higher than the loan, giving lenders a strong buffer. A high LTV leaves little room if asset prices fall, increasing the chance of loss.

3. Borrower’s Financial Strength

Borrowers with stable income and multiple revenue sources can repay part of the loan or agree to restructuring. This reduces losses. Financially weak borrowers usually lack this flexibility, raising LGD.

4. Economic Conditions

During slowdowns, asset prices fall, and cash flows shrink, increasing losses. Strong economies improve recoveries and reduce LGD.

Also, read – 6 Key Benefits of Loan Insurance

Approaches to Calculate & Model LGD (With Examples)

Loss Given Default (LGD) is a key risk measure used by banks to estimate how much money they may lose if a borrower defaults. Under Basel II rules, LGD is used along with Probability of Default (PD) and Exposure at Default (EAD) to calculate expected loss and required capital.

Expected Loss can be calculated using this formula:

Expected Loss = PD × EAD × LGD

There are two commonly used loss given default formulas:

Method 1: Using exposure and recovery rate

This approach focuses on the amount outstanding at default and the portion expected to be recovered. It is widely used because it is simple and conservative, assuming worst-case loss.

LGD (₹ or $) = EAD × (1 − Recovery Rate)

Method 2: Using collateral sale value

This method compares how much money can be recovered by selling collateral against the unpaid loan. It gives a realistic view but is harder to estimate due to sale timing, costs, and asset liquidity.

LGD (%) = 1 − (Sale Proceeds / Outstanding Loan)

Let’s understand this with an example:

Suppose,

Outstanding loan: $300,000

Recovery rate: 20%

Collateral sale value: $200,000

LGD in dollars = $300,000 × (1 − 0.20) = $240,000

LGD as percentage = 1 − ($200,000 / $300,000) = 33.33%

Also, read – Steps to take if you can’t Pay Your Personal Loan

Regulatory Perspective: LGD Under Basel and IFRS 9 in India

In India, banks and financial institutions calculate Loss Given Default (LGD) mainly under two regulatory frameworks: IFRS 9 (for accounting) and Basel norms (for capital and risk management). While both use LGD, their purpose and approach differ.

IFRS 9:

LGD is a key input in the Expected Credit Loss (ECL) model, along with PD and EAD.
LGD estimates must be forward-looking, meaning banks must factor in future economic conditions, not just past data.
If a loan shows a significant increase in credit risk, banks must calculate losses over the loan’s entire lifetime, not just the next year.
LGD models must reflect how recoveries may change due to factors like GDP growth, unemployment, or property prices.
Banks must clearly disclose assumptions, models used, and how changes in economic scenarios impact LGD numbers.

Basel:

LGD is used to calculate regulatory capital and ensure banks can absorb losses.
Banks using advanced models must estimate downturn LGD, assuming stressed economic conditions.
Strong focus is placed on collateral and guarantees, including legal enforceability and valuation quality.
Basel rules set minimum LGD floors to avoid underestimating risk.
LGD models must be regularly validated and back-tested against real recovery outcomes.

Also, read – Loan Life Cycle Explained: From Application to Closure

Best Practices to Reduce and Manage Loss Given Default

Managing Loss Given Default starts with reducing risk before a loan is given and acting early when problems appear. Some simple but effective practices include:

1. Run Credit Checks

Lenders should carefully review a borrower’s credit history, income stability, and repayment behaviour. This helps identify high-risk borrowers early and price or structure loans better.

2. Secure Loans with Quality Collateral

Taking collateral such as property, vehicles, or other valuable assets reduces potential losses. If a borrower defaults, the lender can sell the asset to recover part of the loan.

3. Monitor Loans Regularly

Regular tracking of payments and borrower financial health helps detect stress early. Missed payments or falling income can signal the need for action.

4. Diversify the Loan Portfolio

Spreading loans across different sectors, regions, and borrower types lowers overall risk. This way, problems in one industry do not heavily impact total recoveries.

5. Act Early

Open communication allows lenders to restructure loans, extend tenures, or adjust payments. Supporting borrowers during temporary setbacks often prevents full default.

Conclusion

Loss Given Default is one of the most important concepts used for credit risk management. It allows creditors to have a better estimate of the losses caused by a potential loan default. The metric also aids financial institutions in better managing their risks and avoiding risky credits. Thus, lenders can not only ensure more profitability but also leave room for stability and continuous growth. At Tata Capital, we prioritise effective risk management to ensure you have access to business loans on favorable terms. Visit our website or download our app for quick access to funds at competitive business loan interest rates.

FAQs

What affects Loss Given Default?

LGD is influenced by factors such as collateral type, asset recoverability, borrower’s condition, legal and operational costs, market conditions, and the efficiency of the recovery process.

What is the half-life of LGD?

The half-life of LGD refers to the time taken to recover half of the potential loss. It varies based on collateral type, default circumstances, and the recovery methods used.

What is the cure rate for Loss Given Default?

The cure rate is the percentage of defaulted loans that are recovered or repaid. A higher cure rate results in a lower LGD, indicating more effective recovery efforts.

Can Loss Given Default be greater than 100?

LGD cannot exceed 100%. It represents the percentage of a loan that is lost, and a value above 100% would indicate a loss greater than the total loan amount, which isn’t possible.

Can Loss Given Default Be Zero?

LGD can be zero if the lender recovers the full loan amount through collateral or other means, meaning there’s no loss from the default.

What is the loss given default half-life?

The half-life of LGD refers to the time taken to recover half of the potential loss. It varies based on collateral type, default circumstances, and the recovery methods used.

Can Loss Given Default be greater than 100?

LGD cannot exceed 100%. It represents the percentage of a loan that is lost, and a value above 100% would indicate a loss greater than the total loan amount, which isn’t possible.

What is LGD in credit risk management?

Here’s a simple way to understand what is LGD in credit risk - it shows how much money a lender may lose if a borrower defaults, after considering recoveries from collateral, guarantees, or repayments.

How is LGD calculated? What is the standard loss given default formula?

LGD in finance is commonly calculated as the loan exposure multiplied by one minus the recovery rate, showing the portion of the loan not recovered.

What factors affect LGD in finance?

LGD in finance depends on collateral quality, loan-to-value ratio, borrower strength, recovery process, and economic conditions affecting asset prices and repayments.

What is the difference between LGD and Probability of Default (PD)?

PD measures the chance that a borrower will default, while LGD measures how much money the lender loses if that default actually happens.

How does collateral influence the loss given default?

Good-quality, easy-to-sell collateral reduces LGD by improving recoveries, while weak or illiquid collateral increases potential losses for lenders.

Why is LGD important under Basel and IFRS 9 regulations?

LGD is used to calculate expected credit losses and capital requirements, helping banks measure risk accurately and stay financially stable.

Can loss given default ever be zero?

Yes, LGD can be zero if the lender fully recovers the loan amount through collateral sale, guarantees, or full repayment after default.

How is LGD used to calculate expected credit loss?

LGD is multiplied by Probability of Default and Exposure at Default to estimate expected credit loss under Basel and IFRS 9 frameworks.

Previous Post Disclaimer Next Post

Menu

Loss Given Default (LGD): Meaning, Formula, and Significance in Credit Risk

What is Loss Given Default (LGD) in Finance?

Why Is Loss Given Default Important?

How to Calculate Loss Given Default

Key Factors Influencing Loss Given Default (LGD)

Approaches to Calculate & Model LGD (With Examples)

Regulatory Perspective: LGD Under Basel and IFRS 9 in India

Best Practices to Reduce and Manage Loss Given Default

Conclusion

FAQs

What affects Loss Given Default?

What is the half-life of LGD?

What is the cure rate for Loss Given Default?

Can Loss Given Default be greater than 100?

Can Loss Given Default Be Zero?

What is the loss given default half-life?

Can Loss Given Default be greater than 100?

What is LGD in credit risk management?

How is LGD calculated? What is the standard loss given default formula?

What factors affect LGD in finance?

What is the difference between LGD and Probability of Default (PD)?

How does collateral influence the loss given default?

Why is LGD important under Basel and IFRS 9 regulations?

Can loss given default ever be zero?

How is LGD used to calculate expected credit loss?

Subscribe

Most Viewed Blogs

Trending Blogs

Calculator

Follow Us