Some banks, which have been granted permission to use internal models for credit risk, are introducing in the loss given default (LGD) calculation a risk driver representing the obligors' creditworthiness: the rating (i.e. PD). This is a significant novelty in the LGD estimation process, as it introduces a dynamic component as a driver and a strong correlation effect between the PD and LGD parameters. Through the use of real data collected from the private customers of all Italian banks over the years 2020-23, the impact of including the rating variable in the estimation of the LGD model was assessed, showing a decrease in total RWAs of approximately 9 per cent. Although the interdependency between PD and LGD is not explicitly forbidden in the Basel framework and the current regulations in force, the RWA calculation formula does not take it into account. The analysis concludes by discussing how the incorporation of the rating as an LGD driver may be questionable in the absence of adequate supporting analysis for monitoring and testing performance.
