The Basel norms suggest that organizations assess their own credit risk internally. In order to do so, they are required to calculate the probability of default, exposure at default, and loss given default. The loss given default is the amount of money that is not recovered in the event of a default.

Earlier financial statistical models have made the mistake of considering loss to be a binary event. This means that they assume that either none of the debt given will be recovered or all of it will be recovered. However, this is not the case. There are various factors at play that influence the amount of money that can be recovered in case a default occurs. In this article, we will have a closer look at what recovery rates are and how they influence the management of credit risk at any organization.

What are Recovery Rates?

As mentioned above, recovery rates are the percentage of funds that are actually recovered when a default takes place. It is important to note that the term recovery rate only refers to cases where there is a default. In the absence of default, the recovery rate is bound to be 100%.

In earlier articles, we have learned about the term “loss given default“. It is important to note that “loss given default” is the amount of money that has not been recovered in the event of a default. Hence, if we add recovery rates and loss given default we arrive at the total debt amount.

The calculation of recovery rates is fairly straightforward. However, there a couple of points that need to be considered. These points are accounted for differently in different parts of the world.

• For instance, expenses related to debt collection may be reduced from the recovered amount before calculating the recovery rate in some cases. On the other hand, in some other parts of the world, the amount may not be netted.

• Similarly, there is debate about whether the nominal amount received should be discounted back to reach the real amount recovered. For instance, if a company receives $1000 after 3 years from default, should it consider this as a recovery of $1000 or should it discount the $1000 for three years to reach the real value which would have been realized at that point in time in the absence of default. Once again, in different parts of the world, these points are treated differently.

There are a few more details related to recovery rates which have been mentioned below.

Types of Recovery Rates

There are certain types of recovery rates that are used in credit risk management. A firm’s usage of these different types basically depends upon how the firm values its exposure in the first place.

1. Book Value Recovery: Book value recovery refers to the number of bad debts that have been recovered in comparison to what the book value of the debt was. Let’s say that when the debt was originated, it was worth $100. However, over the years, $60 was paid. Hence, the book value of the outstanding debt was $40. However, after default, the firm was able to recover $20. Here if we compare the $20 with the book value, the recovery rate would be 50%

2. Market Value Recovery: The book value of debt need not be the same as the market value of debt. For example, it is possible for $40 book value debt to have $30 market value. In this case, the recovery rate will be $20 out of $30 i.e. 75%.

3. Settlement Value Recovery: Just like book value and market value, debt can also have a third value which is the settlement recovery value. The settlement recover value is the legal value of the debt to be repaid as decided by the court.

   For instance, if the outstanding loan of $40 was subordinated debt and the court decided that only 50% of the subordinated debt should be paid, then the settlement value, in this case, would be $20. If the firm is able to recover $20, it will be considered to have recovered 100% of its debts compared to the settlement value of the debt.

What Determines Recovery Rates?

Credit risk managers have tried to isolate the factors which commonly influence recovery rates. Some of these factors have been listed below:

1. Collateral and Seniority: It is important to note that the recovery rates are determined by the value of the collateral. If the collateral can be sold to recover the money, then the rates are higher. If the sale of collateral is not sufficient to return the money owed to all shareholders, then the seniority of debts comes into question and influences the final recovery rate.

2. Industry and Competition: The recovery rate is also based on the industry structure and the number of competitors. If the firm going bankrupt is in a competitive industry and there is a high demand for its assets, then it is likely that the recovery rate will be higher. This is because the competitors will bid against each other in order to acquire the assets. In the process, they will end up raising the prices of the assets being sold and hence will increase the recovery rate.

3. Business Cycle: Finally, the recovery rate is also based on the business cycle in the macroeconomy. If the economy is in a boom, then the chances of assets being disposed off at a higher rate are more. As a result, the recovery rate would also increase in such cases.

The bottom line is that recovery rates are important when it comes to managing credit risk proactively and prudently. Details related to the recovery rate in an industry should be studied carefully before giving out loans in order to avoid losses due to credit risk.