A cost of capital approach to determining the LGD discount rate

Loss Given Default (LGD) is a key risk parameter in determining a bank's regulatory capital. During LGD-estimation, realised recovery cash flows are to be discounted at an appropriate rate. Regulatory guidance mandates that this rate should allow for the time value of money, as well as include a risk premium that reflects the "undiversifiable risk" within these recoveries. Having extensively reviewed earlier methods of determining this rate, we propose a new approach that is inspired by the cost of capital approach from the Solvency II regulatory regime. Our method involves estimating a market-consistent price for a portfolio of defaulted loans, from which an associated discount rate may be inferred. We apply this method to mortgage and personal loans data from a large South African bank. The results reveal the main drivers of the discount rate to be the mean and variance of these recoveries, as well as the bank's cost of capital in excess of the risk-free rate. Our method therefore produces a discount rate that reflects both the undiversifiable risk of recovery recoveries and the time value of money, thereby satisfying regulatory requirements. This work can subsequently enhance the LGD-component within the modelling of both regulatory and economic capital.