Discounting long and uncertain workout recoveries for estimating loss given default

Abstract

A key determinant of the loss given default within the Basel II framework is the discount factor used in discounting the recoveries, especially when the workout period is long and uncertain. There is no agreement among practitioners and regulators on an appropriate discount factor selection methodology — quantitative techniques in this area have mostly focused on recoveries on assets traded in the market. Recoveries done by banks on assets not traded in the market, which form a large share of their retail exposures, have been relatively unexplored with respect to a suitable quantitative discounting technique. This paper proposes a quantitative technique that could be easily applied by banks when their workout recoveries are long and uncertain. It also explores the impact of systematic factors in deriving the discount factor. Further, the paper explores the properties of the proposed discount factor and results from retail and corporate exposures of defaulted loans.