The new Basel Capital Accord (Basel II) is going to be embedded in the risk management practices at many financial institutions shortly, but the academic and financial world are still discussing about several topics related to the new capital adequacy rules. One of the most important and prominent examples among these topics is the link between loss given default (LGD) and the economic cycle. If this link exists, which is suggested by an extensive literature, the Vasicek model used in the Basel Accord does not take into account systematic correlation between probability of default (PD) and LGD and, to compensate for this deficiency, downturn LGD estimates are required to be used as an input to the model.
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