IFRS quantitative finance series
IFRS 9 LGD: Collateral, Cure and Discounted Recoveries
LGD turns default into an expected cash shortfall. For secured banking books, the result depends on more than collateral value: timing, enforceability, seniority, costs, cure, re-default and the path of exposure all matter.
Model recovery cash flows
A transparent approach projects collections, collateral proceeds, guarantees and costs through time. Haircuts should reflect market and execution risk rather than act as unexplained prudence. Recoveries that are remote or legally uncertain require evidence before inclusion.
Cure is not zero loss
Accounts can return to performing status after default but still generate arrears, concessions, collection costs or later re-default. Cure and liquidation paths should be modelled consistently, with re-default risk included where material.
Discounting changes the answer
Two portfolios with identical nominal recoveries can have different LGD if recovery timing differs. Slow legal processes increase the present value shortfall. Validation should therefore examine both recovery amounts and timing errors.
Quantitative expression
Implementation controls
- Link collateral to enforceable exposure records.
- Backtest cure, liquidation and re-default separately.
- Measure recovery timing bias.
- Challenge expert haircuts against realised outcomes.