Explain credit concentration risk. What is its relevance for credit portfolio management?
BCBS (2006b) suggested that the concentrations of risk in banks’ credit portfolios emanate from imperfect diversification namely, name concentrations and sector concentrations. Name concentration led to residual undiversified idiosyncratic risk in the portfolio, which causes the underestimation of the required economic capital. Name concentration is sometimes called lack of granularity (BCBS: 2006b:9). Grippa & Gornicka (2016) as a result, name concentration cannot be diversified away perfectly due to large exposures to individual borrowers. Sector concentration emerges when the portfolio is not perfectly diversified across sectoral factors, corresponding to systematic components of risk.
According to Joseph (2013: 258), Portfolio credit risk is influenced by credit portfolio concentration. Concentration risk is the aggregation of exposure risk within a portfolio, which can be caused by loan facilities to a single borrower or industry, or other comparable concentrations. For each aggregation, a bank or financial institution must understand the various concentration risks and determine permissible portfolio concentrations. Concentration risk in credit portfolios has caused bank hardship on numerous occasions throughout history. Portfolio concentrations determine the extent of challenges that a financial institution will face in the event of a crisis. Concentration can occur in a variety of ways, namely industry or sector concentration, exposure or name concentration, region/location/country concentration, foreign currency concentration, collateral risk concentration.
Industry or Sector Concentration
Excessive exposure to a single business or sector can be risky from a portfolio standpoint. Sector-specific downturns are not unusual, as history has shown. Some of the industries are cyclical by nature. While some industries are cyclical, it is important to remember that sensitivity to business cycles differs by industry.
Chemicals, building materials, advertising, recruiting, real estate, and construction are all cyclical industries. For example, it is common to see the construction sector slow down after a building boom, resulting in financial difficulties for numerous industry participants such as construction contractors, building material manufacturers, and suppliers. Excessive exposure to the industry may appear appealing during times of boom, but it could mean disaster when the boom fades. Hence, an ideal portfolio ought to be balanced, with a mix of different industries. Diversification can be achieved by two methods – traditional and modern. Under the traditional method, an assortment of different sectors is selected for diversification, based on internal studies. Modern methods determine scientifically the type and extent of diversification required in the portfolio, drawing upon Portfolio Theories (PT), amongst others.
The importance of sector correlation cannot be overstated. Some industries are so intertwined that when one suffers a setback, it can have a delayed effect on others. For example, the furniture industry will witness sharp growth in a booming residential/commercial construction market. In the event of a construction slowdown, the furniture business would suffer as well, as it is linked to the economy’s construction activity.
Exposure or Name Concentration
According to Joseph (2013:259), the amount exposed to credit risk is termed exposure risk. Even if the firm’s credit risk is adequate, concentrating exposures in a small number of clients can spell disaster. Once this flaw has been found, diversification away from a few concentrated exposures should be prioritized. ABC Ltd, for example, has a credit portfolio of 100 customers worth $200 million. However, one customer’s exposure amounts to $160 million, with the remaining $40 million divided across the remaining 99 customers from various industries. The concentration of exposure is visible in this image. There is an excessive reliance on a single customer, who accounts for 80% of the portfolio. To discover, manage, and minimize similar exposure risks, a portfolio approach is required Joseph (2013:259).
Region/Location/Country Concentration
According to Joseph (2013:259) different geographical regions – particularly in big countries – have different economic features, and their involvement or contribution to the broader economy may differ. Rather than concentrating credit assets in a single region, a portfolio spread throughout a large area provides portfolio comfort. It assures that the whims of a specific region will have no bearing on the portfolio. It’s worth having a classification of regions/countries based on riskiness, just as it is for sectors.
When a bank or financial institution in one country extends credit to obligors in other countries, either through a loan or otherwise, country risk and sovereign risk develop. As a result, international banks, financial institutions, and enterprises with cross-country credit exposures may find it necessary to achieve dispersion among multiple nations in their daily operations.
Foreign Currency Concentration
Currency risk is minimal when credit assets and liabilities are denominated in local currency. Currency risk exists if liabilities and obligations are to be met through the realization of credit assets designated in multiple currencies. Any foreign currency concentration that is exposed to market swings can be troublesome. Even if the currencies are tied, relying on inexpensive foreign currency loans to finance local credit assets may not be optimum, as several Far East Asian enterprises discovered in 1997/98. The abrupt depreciation of local currencies produced major problems for various enterprises in Far East Asian nations, resulting in credit losses for the region’s banks. Diversification and hedging can both be considered currency risk mitigation strategies.
Collateral Risk
To reduce credit risks, many creditors, particularly banks, accept collateral as security. However, it can be a danger at the portfolio level. Consider a scenario in which the creditor only accepts one type of security: real estate with a 50% margin. The portfolio’s comfort diminishes if the property market falls sharply below 50%. During the late 1980s and early 1990s, Japanese banks faced a similar situation when they financed against real estate and discovered that the liquidation of the collaterals was insufficient not only to cover the loans extended but also to meet the interest obligations, let alone the principal, during the recession that followed. Many of these incidents resulted in bank failures. The significant drop in real estate assets held as collateral contributed to the subprime mortgage crisis in the United States in 2008. The moral of the story is that I collateral portfolio concentration risks can be avoided, (ii) collateral values can peak and collapse, (iii) collateral market value can be positively correlated to business cycles, and (iv) if the collateral value has a strong positive correlation with an obligor’s creditworthiness, this is a significant source of risk known as ‘wrong way correlation.’ The subprime mortgage crisis in the United States in 2008 is similar to what occurred in Japan in the late 1980s.
Relevance of concentration in credit portfolio management
As stated above, concentration helps banking institutions in the management of risk in an organization, in the sense that it assists banks in picking the right mixes for a portfolio and thus helps in diversifying the risk across various assets. Positive and negative correlation assets should be mixed in order to spread the risk away. The correlation value ranges from +1 (perfect positive correlation) to –1 (perfect negative correlation), with 0 indicating no association at all. Both variables are flowing in the same direction and may be influenced by the same underlying sources or causes. Negative correlations indicate that both variables react to external stimuli in opposite ways.
Returning to the importance of correlation in credit portfolio risk management, historical research suggests that credit risk has a correlation that changes across business cycles and enterprises. During economic downturns, the credit risk connection also rises. As a result, it is acceptable to assume that overall credit risk is positively connected with economic downturns from the standpoint of systematic risk. This knowledge should come in handy when putting together a credit portfolio. Because non-cyclical industries are less affected by economic downturns, their correlation to the slump is smaller. Construction, the financial industry, and real estate, on the other hand, have a larger correlation, implying that economic upheaval has a greater impact on these industries. Correlation studies can be divided into various categories based on their needs; for example, sector-specific correlation and default correlation are described below:
- Sector correlation: When all other factors are equal (i.e. acceptable obligor credit risk), sectors with negative correlation are the best option for building a credit portfolio. (See also the Diversification chapter.)
- Default correlation: When the credit risk of the obligor is considerable, sector correlation becomes meaningless. Regardless of industry diversity, the risk of default increases when obligor credit risk deteriorates. As a result, the default correlation increases as the credit rating declines in quality. This demonstrates the significance of obligor credit risk analysis, which we covered in-depth in the preceding portions of the book.
References
BCBS (2006b)
Grippa, P. & Gornicka, L. (2016). Monetary and Capital Markets Department
MEASURING CONCENTRATION RISK – A PARTIAL PORTFOLIO APPROACH. IMF.