How are recovery rates modeled in practice and what factors affect LGD estimation?
I'm working through the credit risk section of FRM Part II and need to understand recovery rate modeling. The material mentions that LGD is not simply (1 - recovery rate) and that recovery rates vary significantly. What drives this variation and how do practitioners model it?
Recovery rate modeling is crucial because Loss Given Default (LGD) directly scales expected and unexpected credit losses. LGD = 1 - Recovery Rate, but the devil is in the details of estimating that recovery rate.
Key Factors Affecting Recovery Rates
- Seniority of the Claim
Historical averages show stark differences:
| Seniority | Average Recovery | Std Dev |
|---|---|---|
| Senior Secured | 65-70% | 25% |
| Senior Unsecured | 40-50% | 30% |
| Subordinated | 25-35% | 25% |
| Junior Subordinated | 15-20% | 20% |
- Industry Sector
Capital-intensive industries with tangible collateral (utilities, manufacturing) tend to have higher recoveries than service or tech firms with intangible assets.
- Economic Conditions at Default
Recovery rates are procyclical — they drop during recessions precisely when default rates spike. This creates "wrong-way risk": LGD and PD are positively correlated.
- Jurisdiction and Legal Framework
Countries with creditor-friendly bankruptcy laws (UK, Germany) see higher recoveries than debtor-friendly regimes.
Modeling Approaches
Example: Crestview Bank estimates LGD for its commercial loan to Beltway Logistics. The loan is senior secured against fleet vehicles. Using workout LGD on similar historical defaults, recovery was 62%. However, it's currently a recession — applying a downturn adjustment of -15 percentage points gives a stressed recovery of 47%, or LGD of 53%.
Basel Requirements: Under Basel IRB, banks must use downturn LGD estimates — the recovery rate expected during stressed economic conditions, not the long-run average. This prevents underestimation of capital requirements.
For the FRM exam, focus on the distinction between workout, market, and implied LGD, and understand why downturn LGD is required for regulatory capital. Explore our FRM practice questions for more scenarios.
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