2.1 Introduction

1. The quantification of downturn LGD has been challenging for competent authorities, industry and academics alike ever since the Basel II framework introduced this concept. The requirement for loss given default (LGD) and conversion factor (CF) estimates to reflect economic downturn conditions was introduced in the Basel II capital framework and stems from the general economic model that is used to derive the formula for calculating minimum own funds requirements. In the Basel II capital framework, unexpected losses are based on the conditional expected loss given a high confidence level for the single systematic risk factor leading to high credit losses. Whereas the risk weight formula includes a supervisory mapping function to derive conditional probabilities of default (PDs) [That is conditional on a set value of the single systematic risk factor (i.e. based on the 99.9% confidence level).] from unconditional long-run average PDs estimated by the institutions, it does not provide an explicit function that would transform long-run average LGDs and exposures at default (EADs) into conditional LGDs and exposure values (respectively CFs). Instead, it requires institutions to use LGDs that are appropriate for an economic downturn. The lack of explicit guidance and limited supervisory and industry consensus on how to incorporate the economic downturn component in model estimation has led to significant differences in practices and has given rise to unwarranted variability in risk-weighted exposure (RWE) amounts when own estimates of LGDs and/or CFs are used.