Concentration Risk

The quantification of Credit Risk has both normal and stressed modes of measurement, just as all measures of risk do. However, when an analyst attempts to quantify stress in credit portfolios, they should attempt to dimension the concentration risk aspects of their portfolio in line with the stress test they have in mind.

  

In this blog post we look at the stress testing aspects around concentration risk and a presentation has also been attached to the end of this journal which can be downloaded. This presentation investigates standard and accepted practices for measuring concentration risk in credit portfolios.

Understanding Concentration Risk

Concentration risk is generally a credit risk concern for the banking community although the hazard is not reserved for bankers alone or credit risk specifically for that matter. Concentration risk in the Basel context is the "spread" of outstanding obligors or specifically the level of diversity that exists across a bank's loan portfolios. The lower the diversity, the higher the credit concentration risk. Well that is how the story goes.

Concentration risk can present itself in many ways and I have taken to list five common causes below:

[1] GEOGRAPHIC CONCENTRATION

If a loan portfolio is made up of obligors in one geographical location, then the propensity increases for a single event such as an environmental catastrophe to impact a larger aspect of the portfolio.

[2] SECTOR CONCENTRATION

Individual firms in a unique industry sector are impacted by targeted market events such as the change of regulation or an increase in commodity prices. In concentrated portfolios each firm is impacted in a similar manner by an adverse event.

[3] PRODUCT & CHANNEL CONCENTRATION

Counterparties may be separated by geography and sector but may be homogeneous due to their balance sheet structure.  Banks have a tendency to design specific products for unique economic conditions and firms attempting to satisfy these conditions are generally aligned in financial or operating structure. These counterparties become concentrated in nature once again.

[4] CONTRACT CLUSTERING
The loan portfolio will always be decaying (run off) and will be added to overtime. Firms have a propensity to default at specific times across their loan contracts. Additionally, loans are generally sold during unique economic cycles which can create calendar and contract tenure clustering.

[5] ALL EGGS IN ONE BASKET SYNDROME

Banks which derive the majority of their loan revenues from large pools of single counterparties, will suffer "all eggs in the one basket syndrome".  That is, a single default from a proportionately large counterparty may deeply hamper the portfolios prospect to remain profitable.

Presentation on Concentration Risk [link] | Martin Davies

A presentation for measuring concentration risk can be found by following this [link] and includes case studies from different analysts along with a quick sample model for concentration risk.