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Jon Frye
The views expressed are the authors and do not necessarily represent the views of the management of the Federal
Reserve Bank of Chicago or the Federal Reserve System.
Stress tests
Dodd-Frank requires big banks to stress test loans.
The Fed specifies several economic scenarios.
In a typical scenario the economy deteriorates, bottoms out,
and begins to improve within a nine-quarter horizon.
LGD is noisy.
Seemingly similar loans can have very different LGDs.
The remedy for noisy data is to have lots of cases.
80%
Bad years
12%
60%
Average LGD in
good years
= 52%
LGD Rate
Default Rate
Similar response
8%
40%
4%
20%
0%
0%
30%
LGD0 = 25%
20%
PD0 = 2%
LGD
10%
0%
0%
PD
2%
4%
6%
8%
10
11
30%
LGD0 = 25%
20%
Quarter t PD = 6%
PD0 = 2%
LGD
10%
0%
0%
PD
2%
4%
6%
8%
12
60%
The effect of a change in PD is
nearly the same
40%
20%
LGD
0%
0%
PD
5%
10%
15%
13
40%
cLGD
30%
20%
cDR
10%
0%
5%
10%
15%
20%
25%
30%
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Summary
The LGD function is easy to apply in a stress test.
If you know a loans current PD and current LGD, you know its
LGD function.
Questions?
16
References
Jon.Frye@chi.frb.org
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