Concentration risk

What is Concentration risk?

Concentration risk is the risk that an investor will suffer from lack of diversification, investing too heavily in one industry, one geographic area or one type of security. Concentration risk is the risk of loss arising from a large position in a single asset or market exposure. An excessive concentration can give rise to liquidity risk or market risk losses.

Concentration risk is a banking term denoting the overall spread of a bank’s outstanding accounts over the number or variety of debtors to whom the bank has lent money. This risk is calculated using a “concentration ratio” which explains what percentage of the outstanding accounts each bank loan represents. For example, if a bank has 5 outstanding loans of equal value each loan would have a concentration ratio of 0.2; if it had 3, it would be 0.333.

Various other factors enter into this equation in real world applications, where loans are not evenly distributed or are heavily concentrated in certain economic sectors. A bank with 10 loans, valued at 10 dollars a piece would have a concentration ratio of 0.10; but if 9 of the loans were for 1 dollar, and the last was for 50, the concentration risk would be considerably higher. Also, loans weighted towards a specific economic sector would create a higher ratio than a set of evenly distributed loans because the evenly spread loans would serve to offset the risk of economic downturn and default in any one specific industry damaging the bank’s outstanding accounts.

Credit concentration risk means part of credit risk that measures the risk concentration to any single customer or group of closely-related customers with the potential of producing losses which are substantial enough to affect the financial soundness of a financial institution.

Risk of default is an important factor in concentration risk. The basic issue raised by the concept of default risk is: does the risk of default on a bank’s outstanding loans match the overall risk posed by the entire economy or are the bank’s loans concentrated in areas of higher or lower than average risk based on their volume, type, amount, and industry.

The term “concentration risk” in the context of banking generally denotes the risk arising from an uneven distribution of counterparties in credit or any other business relationships or from a concentration in business sectors or geographical regions which is capable of generating losses large enough to jeopardise an institution’s solvency.

Concentration risk can be considered from either a macro (systemic) or a micro (idiosyncratic) perspective. From the point of view of financial stability (macro perspective), the focus is on risks for groups of banks which, for example, emerge from a joint concentration in certain business lines or a joint regional concentration in lending. Economic disruptions which affect the group of joint borrowers or the region can therefore jeopardise the solvency of an entire group of banks and thus put financial stability at risk. By contrast, the primary focus in internal risk management and from a supervisory point of view is on concentration risk at the level of individual institutions (micro perspective). This risk is not limited to credit portfolios and may stem from various sources.

In lending business, not only a concentration of borrowers but also a concentration of counterparties in trading activities or of certain collateral instruments or collateral providers may occur. Market risks – for example, large exposures in a particular currency – may also lead to concentration risk.

Concentration in liabilities, such as a concentration of certain refinancing instruments or of investors or depositors, may also play an important role. These concentrations belong more to a bank’s general liquidity risk, however. Furthermore, concentration risk is also inherent in the area of operational risk, for example, through dependence on a particular IT system.

Traditionally, a distinction is made between a concentration of loans to individual borrowers – also termed single-name concentration or granularity – and an uneven distribution across sectors of industry or geographical regions (sectoral concentration).

Types of Concentration risk

There are two types of concentration risk. These types are based on the sources of the risk. Concentration risk can arise from uneven distribution of exposures (or loan) to its borrowers. Such a risk is called name concentration risk. Another type is sectoral concentration risk, which can arise from uneven distribution of exposures to particular sectors, regions, industries or products.

How to identify Concentration risk?

Methods and systems of identifying concentration risk should be commensurate with the size of the institution, the levels of inherent concentrations, and the importance of the activity to the institution. The basic building block of a good identification system is the ability to store and access data. Systems should also apply some controls to help ensure the data is entered as accurately as possible. Information related to the attributes of the loans such as loan type, balances, limits, rates, dates; to the characteristics of the borrower; name, credit score, etc., and information related to the collateral such as address, value, and senior liens should be accessible for analysis.

If an institution does not have this data capability in house it should contract with a third party provider and of course, conduct proper due diligence on any such vendor to ensure confidential information is handled appropriately and the vendor is generally operating in a safe and sound manner.

How to measure Concentration risk?

The board of directors must establish policies which address concentration risk limits. The board should take into account company strategy, economic conditions, and net worth levels in setting such limits.

Most financial institutions will have limits or not to exceed thresholds for certain common concentrations, such as by lines of business, types/sectors of lending, geography, ratings/grades segments, and to a single borrower or related set of borrowers. These thresholds can be tracked as a percentage of the loan portfolio, the institution’s total assets or the institution’s net worth.

Monitoring and management of Concentration risk

Most financial institutions have policies to identify and limit concentration risk. This typically involves setting certain thresholds for various types of risk. Once these thresholds are set, they are managed by frequent and diligent reporting to assess concentration areas and identify elevated thresholds.

A key component to the management of concentration risk is accurately defining thresholds across various concentrations to minimize the combined risks across concentrations.

The first step in managing concentration risk is to understand how it might occur. Concentration can be the result of a number of factors:

  • Intentional concentration;
  • Concentration due to asset performance;
  • Company stock concentration;
  • Concentration due to correlated assets;
  • Concentration in illiquid investments.

Management should actively monitor concentration risk through the use of regular formal reporting. Larger institutions will probably find it beneficial to have a committee focus their attention and expertise on monitoring this reporting.

Management should also have a plan of action in place if concentrations levels approach or exceed established thresholds. For example:

  • Curtailing marketing effort;
  • Increasing rates and or raising approval criteria;
  • Reducing related policy limits;
  • Transferring risk to other parties; and/or
  • Closing down the product completely or until concentrations levels have subsided.