Incorporating small-sample defaults history in loss given default models

This paper proposes a methodology for estimating loss given default (LGD) that accounts for small default sample sizes. Regulatory guidelines for estimating LGD state that it is essential to take into account all observed defaults from the selected time period. In many portfolios, such as those for many emerging markets, the number of observed defaults is limited. Further, methodologies that exclude information from unresolved defaults produce biased estimates. We show that the distribution of LGD is bimodal, and we develop an estimation approach that uses a combination of logistic and linear regression to produce more reliable estimates. We implement our methodology for a sample of loans of a Polish bank, and demonstrate refinements to our modeling that produce the most precise final estimates of LGD.