What LGD floors does Basel III final impose and how do they vary?

Question

AcadiFi · Accepted Answer

Basel III finalization introduced input floors on LGD estimates for A-IRB exposures to prevent excessively optimistic loss estimates, particularly for well-collateralized lending.

**LGD floors for secured corporate exposures:**
- Financial collateral: 0% (subject to haircuts and comprehensive approach)
- Receivables: 20%
- Residential/commercial real estate: 20%
- Other physical collateral: 25%

**LGD floors for unsecured corporate exposures:** 25%

**LGD floors for retail:**
- Residential mortgage (secured): 5%
- QRRE: 50%
- Other retail unsecured: 30%

Example: Larchwood Regional Bank has a $40M commercial real estate loan to Brightharbor Developments, secured by office building worth $58M (LTV 69%). Internal A-IRB LGD model estimates LGD = 12% based on historical workout data.

After floor: LGD = 20% (CRE minimum). Impact:
- RWA with internal LGD 12%: using K formula → RWA ≈ $15.2M
- RWA with floored LGD 20%: RWA ≈ $25.3M (+66%)

```mermaid
flowchart TD
  A[Exposure type] --> B[Secured corp]
  A --> C[Unsecured corp]
  A --> D[Retail mortgage]
  A --> E[Retail QRRE]
  B --> F[LGD floor 20-25%]
  C --> G[LGD floor 25%]
  D --> H[LGD floor 5%]
  E --> I[LGD floor 50%]
```

For F-IRB (Foundation), LGD is supervisory-set (not estimated by bank), so floors don't apply in the same way — the supervisory LGDs themselves (45% senior unsecured, 75% subordinated) effectively serve as mandated values.

Output floor interaction: Total IRB RWA must be ≥ 72.5% of Standardized RWA, adding a second protection layer against aggressive internal models.

What LGD floors does Basel III final impose and how do they vary?

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