Measuring and managing concentration risk

Abstract

Concentration risk 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 jeopardize an institution’s solvency. Concentration risk can arise from either a macro (systematic) or a micro (idiosyncratic) perspective. Traditionally, a distinction is made between a concentration of loans to individual borrowers - also termed single-name concentration or granularity – and uneven distribution across sectors of industry or geographical regions called sectoral concentration. A further risk category consists of risks arising from a concentration of exposures to enterprises connected with one another through bilateral business relations. The resultant danger of contagion effects in the event of default on the part of one of these borrowers has, however, received attention only in recent research. Specialized banks and credit institutions accept credit concentrations to benefit from informational advantages. However there have been many instances of crises due to increased concentration of risk. Basel II 770 and 771 mention that “Risk concentrations are arguably the single most important cause of major problems in banks and particularly credit risk concentrations are often the most material risk concentrations within a bank.” Concentration and Leverage are a deadly combination. All banks are leveraged operations as 100% equity financed banks are not economically feasible. Most bank failures in the past are due to concentration of one form or another