We get it, no one really wants to talk about default. There are topics way more fun than this. But if you’re in the business of lending money, it’s not just a reality; it’s a daily consideration.
Loss Given Default is a critical metric that determines just how much lenders lose when a borrower fails to repay. In this article, we’ll demystify LGD—what it is, what drives it, and why understanding it well can be the difference between sinking and swimming in the world of credit risk.
What Is Loss Given Default?
Loss Given Default (LGD) is the proportion of a loan that a lender ultimately writes off when a borrower defaults. More precisely, it’s the percentage of the Exposure at Default—the outstanding loan balance at the point of default—that is not recovered through repayments, collateral, or other means.
Put more simply: if you lend $100, the borrower defaults, and you recover $30 through whatever means available, your LGD is 70%. That 70% is your financial bruise. Now imagine that happening thousands of times across a portfolio—that’s not just a bruise anymore.
What Makes Up LGD?
LGD is made up of different components that come together to form the final loss:
- Cure Rates: The surprisingly hopeful part. Some borrowers end up paying off their arrears and return to their contractual repayment schedule. No loss.
- Collateral Recoveries: If the loan is secured, the lender may be able to sell the asset (property, vehicle, or even livestock), and claw back some of the money.
- Costs to Recover: Liquidators, lawyers, agents—they all need to be paid. Payments made voluntarily after default, particularly in unsecured lending where there’s nothing to seize.
- Costs to Recover: Liquidators, lawyers, agents—they all need to be paid.
Each of these layers contributes to the eventual loss. Understanding and predicting each piece is what makes or breaks a successful lender.
Collateral vs Controls: What’s Actually Backing Your Loan?
We often hear loans described as “secured.” But what does that really mean?
There are two main mechanisms to support a loan:
- Collateral: Physical or financial assets you can legally repossess and sell. Think houses, cars, machinery, and even livestock.
- Controls: Legal or contractual leverage that doesn’t involve physical assets. Things like caveats (which stop someone from selling their house out from under you), personal guarantees, and general security agreements (GSAs).
Interestingly, GSAs blur the line between the two. On paper, they’re collateral, giving the lender recourse to all business assets. In practice, they often act more like controls unless the lender actively values and seizes assets. Many lenders hold GSAs to exert control over business borrowers in default when the business has limited tangible assets of value.
Controls don’t provide the same level of comfort or recoveries as collateral, but they still affect borrower behaviour. After all, no one wants to give up control of their business or explain to their spouse that they lost the house because of a director’s guarantee they signed.
Cure or Liquidation: Two Paths, One Default
When a loan defaults, there are generally two routes:
- Cure: The borrower makes good. All arrears are paid, and the loan gets back on track. This is the best-case scenario—no loss.
- Liquidation: The loan remains in default, and enforcement action is needed. This is where things get messy (and costly).
Cure rates depend on multiple factors: interest rates (higher rates equal lower cure rates), the level of security (well-secured loans cure more often), and borrower complexity (simple businesses are more likely to rebound). In short, if you want a higher chance of a cure, lend at a reasonable rate to someone with a boring balance sheet.
Haircuts and Recovery to Valuation Ratios (RVR)
A “collateral haircut” is the difference between an asset’s appraised value and the amount the lender expects to recover if they have to sell it.
Enter the Recovery to Valuation Ratio (RVR): this is the actual recovery from a defaulted asset sale divided by the valuation of that asset.
- For residential property, RVRs average around 85–90%, which is fairly reassuring unless you’re in a remote area or the property is next to a sinkhole.
- Commercial property RVRs are typically between 60-75% depending on location and whether the property is specialised or not.
- Business assets? Wildly inconsistent. RVRs range from 0% (asset is unrecoverable) to over 100% in some rare cases. The average recovery is in the 30-50% range.
- And livestock? Surprisingly stable. Animals tend to hold or increase value over the loan term.
Understanding the variance in RVRs is crucial. The more volatile the RVR, the higher the expected LGD—even if the average looks decent on paper.
LGD by Asset Class: It’s Not One Size Fits All
Property Lending
The big drivers here are location, loan-to-value ratio (LVR), and property type. Urban properties in high-demand postcodes tend to sell quickly and at good prices. Rural and mining town properties? Not so much.
Asset Finance and Auto Loans
Here, it’s all about depreciation. Vehicles and business equipment don’t hold their value. The asset’s worth is a sliding slope from day one, which means recovery values are more predictable but often low. However, asset finance tends to be less sensitive to economic cycles than property lending.
Livestock Finance
Livestock typically appreciate during the loan term (they grow, after all), and DLVR (Dynamic Loan-to-Value Ratio) remains below 100%. Just make sure your borrowers have flood insurance.
Invoice Finance
This one is trickier. Most losses here don’t come from credit risk but from fraud. Your LGD is 100% if the invoices aren’t real. Strong operational controls (like lockbox accounts and independent verification), setting advance rate at 85% or lower and avoiding large concentrations to single debtors will help minimise losses.
GSA-Secured Lending
GSAs can deliver good recoveries—if the business has tangible assets of significant value and the lender has the operational processes in place to repossess and sell those assets. Otherwise GSAs act as a significant control and can still provide an incentive for the borrower to repay arrears if they are able.
Unsecured Lending
This is the high-risk, high- stakes end of the lending spectrum. There’s no collateral safety net. As a rule-of-thumb the higher the interest charged on unsecured lending the lower the cure rates and higher the LGD. Your best hope lies in controls (caveats and guarantees) and early collections actions to get in the front of the line of creditors. Realistic LGDs for unsecured loans hover around 70% (plus or minus 10% depending on how high the interest is on the loan).
Why It Matters
Understanding LGD affects everything from pricing and provisioning to capital requirements and loan strategy. Get it wrong, and you could be underestimating risk, mispricing your products, or undercapitalised in a downturn. Get it right, and you’re better equipped to grow sustainably.
At Open Analytics we have spent years building robust, data-driven LGD models for lenders of all shapes and sizes—from fintech startups to the big four banks. Our models don’t just churn out numbers; they reflect the messy, nuanced reality of lending in the real world.
Final Thoughts: What’s in Your Portfolio?
If you’re a lender, investor, or risk manager, the key takeaway is this: LGD isn’t just about the headline loss figure. It’s a reflection of how well you understand your borrowers, your assets, your controls, and your ability to respond when things go sideways.
At Open Analytics, we help clients unpack that complexity.