Making use of survival analysis to indirectly model loss given default

Abstract

A direct or indirect modelling methodology can be used to predict Loss Given Default (LGD). When using the indirect LGD methodology, two components exist, namely, the loss severity component and the probability component. Commonly used models to predict the loss severity and the probability component are the haircutand the logistic regression models, respectively. In this article, survival analysis was proposed as an  improvement to the more traditional logistic regression method. The mean squared error, bias and variance for the two methodologies were compared and it was shown that the use of survival analysis enhanced the model's predictive power. The proposed LGD methodology (using survival analysis) was applied on two simulated datasets and two retail bank datasets, and according to the results obtained it outperformed the logistic regression LGD methodology. Additional benets included that the new methodology could allow for censoring as well as predicting probabilities over varying outcome periods.

Key words: loss given default, survival analysis, indirect approach, Basel.