Downturn Loss Given Default: Mixture distribution estimation

The internal estimates of Loss Given Default (LGD) must reflect economic downturn conditions, thus estimating the "downturn LGD", as the new Basel Capital Accord Basel II establishes. We suggest a methodology to estimate the downturn LCD distribution to overcome the arbitrariness of the methods suggested by Basel II. We assume that LCD is a mixture of an expansion and recession distribution. In this work, we propose an accurate parametric model for LCD and we estimate its parameters by the EM algorithm. Finally, we apply the proposed model to empirical data on Italian bank loans. (C) 2014 Elsevier B.V. All rights reserved.