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The Basel norms suggest that organizations assess their own credit risk internally. In order to do so, they are required to calculate the probability of default, exposure at default, and loss given default. The loss given default is the amount of money that is not recovered in the event of a default.
Earlier financial statistical models have made the mistake of considering loss to be a binary event. This means that they assume that either none of the debt given will be recovered or all of it will be recovered. However, this is not the case. There are various factors at play that influence the amount of money that can be recovered in case a default occurs. In this article, we will have a closer look at what recovery rates are and how they influence the management of credit risk at any organization.
As mentioned above, recovery rates are the percentage of funds that are actually recovered when a default takes place. It is important to note that the term recovery rate only refers to cases where there is a default. In the absence of default, the recovery rate is bound to be 100%.
In earlier articles, we have learned about the term “loss given default“. It is important to note that “loss given default” is the amount of money that has not been recovered in the event of a default. Hence, if we add recovery rates and loss given default we arrive at the total debt amount.
The calculation of recovery rates is fairly straightforward. However, there a couple of points that need to be considered. These points are accounted for differently in different parts of the world.
There are a few more details related to recovery rates which have been mentioned below.
There are certain types of recovery rates that are used in credit risk management. A firm’s usage of these different types basically depends upon how the firm values its exposure in the first place.
For instance, if the outstanding loan of $40 was subordinated debt and the court decided that only 50% of the subordinated debt should be paid, then the settlement value, in this case, would be $20. If the firm is able to recover $20, it will be considered to have recovered 100% of its debts compared to the settlement value of the debt.
Credit risk managers have tried to isolate the factors which commonly influence recovery rates. Some of these factors have been listed below:
The bottom line is that recovery rates are important when it comes to managing credit risk proactively and prudently. Details related to the recovery rate in an industry should be studied carefully before giving out loans in order to avoid losses due to credit risk.
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