Loss Given Default measures the amount of loss suffered by a bank when one of its debtors fails to repay a loan. This amount is not automatically measured in terms of the amount of money that is not repaid, because the bank might have collateral that can mitigate the loss. Since this is the case, banks often measure Loss Given Default, or LGD, as a percentage of the loss compared to the amount of potential exposure to loss. Banks usually are concerned with the overall LGD of all of their combined loans rather than worrying about it on a loan-by-loan basis.
Considering the large amount of loans given out by a bank at any given time, the possibility always exists that some of those people or entities to whom money was loaned might suffer circumstances that won't allow them to pay back that money. Although this is a fact of life in the banking business, banks still must account for these losses and make sure that those losses don't put too large a dent in their operations. Loss Given Default is one way to measure these losses.
The crucial concept of Loss Given Default is the understanding that defaults cannot simply be measured in terms of the amount of money that was originally loaned. Just about every loan that a bank grants demands collateral to be put up by the borrower. This can come in the form of commercial or residential real estate, a business that the borrower might own, or other assets that the bank might require as insurance against a default. Therefore, there is rarely a case where a bank loses out on the entirety of its loan.
For a simplified example, imagine that a bank loans a company $1,000,000 U.S. Dollars (USD). The company puts the building that is its base of operations, valued at $750,000 USD, up as collateral to secure the loan. If the company goes under before it can make any of the loan payments, the bank can recoup some of its capital by taking possession of the building. Thus the Loss Given Default in this particular situation would be the $1,000,000 USD minus $750,000 USD, yielding $250,000 USD, or 25 percent of the original loan.
It is important to note that each bank uses its own specific formula for determining Loss Given Default. Each bank takes into account the range of collateral it allows, the specifics of its clientele, its standing in the market, and other site-specific factors to figure out how much percentage of loss is acceptable. This percentage is usually measured in terms of the bank's entirety of loss and exposure when all loans are measured.