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Managing Concentration Risk in Banking: Traditional Approaches and New Developments

Explore the traditional approaches to concentration risk in banking, including credit risk, market risk, liquidity risk, and legal risk. Discover new developments and current practices in managing concentration risk and the importance of stress testing.

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Managing Concentration Risk in Banking: Traditional Approaches and New Developments

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  1. Outline • Traditional approach to concentration risk • New developments • Current practices • Name and sector concentration • Stress testing credit concentration risk

  2. Traditional approach • Concentration risk is the probability of suffering losses as a result of a high exposure to a risk factor • Its importance is based not in itself, but in the role it plays as other-risks amplifier • Credit risk concentration • in a few borrowers/industries/regions increases significantly credit risk per se • Enron, Worldcom, Parmalat (early 00s) • Exposures to Latin America (early 80s) • US Texan banks dependence on oil

  3. Traditional approach • Concentration of trading books in a few stocks (or in a few traders) increases market risk significantly • Concentration of business in certain currencies increases exchange rate risk • Concentration in wholesale markets to fund loan growth increases liquidity risk • Concentration in a market channel (i.e. only branches, or only internet banking) increases business risk • Concentration in badly documented loans increases legal risk

  4. Traditional approach • Our experience as banking supervisors tells us that credit risk concentration is always present in a banking crisis as a worsening factor • Either through a concentration in a few very risky borrowers (gamble for resurrection) • Or a concentration in the own banking group firms • Caution with banks that own industrial groups • Lower interest rates, higher loan amounts, less collateral • Lack of market discipline • More easily available finance that leads the industry to increase size unchecked and, finally, brings down the bank

  5. Traditional approach • The answer to credit concentration risk comes from: • Bank managers • Establish, monitor and enforce limits to exposures • Based on the size of the loan • Branch level, regional managers, country managers, central risk committee • Risk diversification (names, industries, regions) • Bank supervisors • Establish quantitative thresholds to exposures… • … on credit risk but also on exchange rate open positions, on tangible assets investments, on non-financial firms equity,…

  6. Traditional approach • Limits on credit exposures by bank supervisors (at the European Union level) • Definition of large exposure • Exposures with individuals or firms representing more than 10% of the equity of the bank • For those large exposures, there are two limits: • The exposure cannot be larger than 25% of the own funds of the bank (20% if the exposure is with a firm member of the own banking group) • The total large exposures cannot be larger than 8 times the own funds of the bank • Public sector and interbank exposures are not included

  7. Traditional approach • Is it wrong to concentrate exposure on AAA borrowers? • Historically risk concentration worsens credit risk • AAA may be downgraded • Risk diversification: 1 loan 1,000 million € vs 1,000 loans of 1 million € • Is it wrong to fund loans growth mainly with retail deposits?

  8. Traditional approach • There is a trade off between specialization and diversification • More diversification (names/regions/industries) means less credit risk • However, more diversification allows for a larger buffer to take on additional credit risk • Shareholders may diversify by themselves • More specialization means a much deeper customer knowledge (avoid risky ones) • However, there can be asymmetric shocks (industry/region)

  9. New developments • Concentration in credit portfolios is an important aspect of credit risk • There are two types of imperfect diversification • Name concentration / Sector concentration • The existence of concentration risk violates one or two assumptions of the ASRF model that underpins IRB approach in Basel II • Perfect granularity / only one risk factor (one systematic component) • BCBS RTF Concentration Risk Group • State of the art / departures from ASFM / stress tests • BCBS WP No. 15, November 2006

  10. Name /sector concentration • Name concentration • Imperfect diversification of idiosyncratic risk in the credit portfolio • Small size of the portfolio • Large exposures to specific individual obligors • Sector concentration • Imperfect diversification across systematic component of risk (i.e. sectional factors)

  11. Survey of best practice • Banks and supervisor differ about concentration risk • For bank supervisors • We interpret concentration risk as a positive or negative deviation from Pillar 1 minimum capital requirements from a framework that does not account for concentration risk • For banks • They perceive concentration risk (they call it diversification) as delivering capital relief from Pillar 1, which they take as the non-diversified benchmark

  12. Survey of best practice • Banks have different measures to capture and manage concentration risk • Exposure limit systems • Using simple measures as the Herfindahl-Hirschman index • Do not capture risk from distinct but correlated exposures (oil and commercial property) • Decided based on strategic considerations, not only on concentration risk • Internal economic capital models • Sometimes constrained by data problems • Focused on asset correlations among sectors

  13. Survey of best practice • Banks have different measures to capture and manage concentration risk • Pricing tools incorporating concentration risk (a few banks) • Concentration risk is generally managed on a centralised basis through monitoring exposures • Different methods of stress testing concentration risk • Downgrade of all large exposures or of a large sector • Increase in exposures to a cluster of borrowers • Increase of PD and/or LGD of a group of exposures

  14. Name concentration • The HHI is used as a credit portfolio concentration measure • The sum of squared market shares (in fractions) of each loan • Between 0 (perfect granularity) and 1 (only one loan) • If the credit portfolio is not fully diversified with respect to individual borrowers, the ASRF model understates the required economic capital

  15. Name concentration • Nevertheless, the lack of granularity does not seem to have a large impact on capital requirements • For large credit portfolios of more than 4,000 loans, name concentration contributes between 1.5% and 4% of portfolio VaR • For smaller portfolios (between 1,000 and • Accounting for name concentration • Adjust the economic capital depending on the HHI • Ad hoc adjustment • HHI does not measure the increase in credit risk • Model-based approaches

  16. Sector concentration • Economic performance is not fully synchronised across different geographic regions, even inside large countries (US) • Exposures in foreign jurisdictions can be subject to additional country-specific risks • Similarly, different industries can experience different cycles • Different industries/regions should be represented by distinct systematic risk factors • The deviation of a single risk factor model of the adequate level of economic capital depends on the degree of imbalances in exposures by industries/regions and the correlation among different industries/regions

  17. Sector concentration • A single-factor model cannot capture all aspects of credit risk in a multi-risk-factor environment • However, the IRB model was calibrated to capture economic capital in large credit portfolios that are well diversified across sectors (risk factors) • IRB might produce more or less capital than what would be appropriate for a real portfolio (depending on diversification of exposures and correlations across industries/regions • As the correlations between sectors increase, the departure from a single-factor model declines

  18. Sector concentration • How important is sector concentration on economic capital? • Results vary across studies • However, the impact of sector concentration seems larger • For a corporate portfolio (GE, but similar in BE, FR and SP), economic capital might increase from 7.8% in the most diversified benchmark to 11.7% for a portfolio concentrated in a single sector • Different results in between for medium-sized or regional banks • Caveats: not taking advantage of diversification benefits from retail portfolios (SMEs, mortgages, consumer loans, credit cards, exposures,…)

  19. Sector concentration • How to deal with sector concentration? • Risk is inherently multi-dimensional, thus, we need multi-factor models • A multi-factor model is the theoretically correct and most general approach to deal with the potential shortcomings of the ASRF model • However, most multi-factor models do not admit a tractable, close-form solution and require a numerical solution (i.e. Monte-Carlo simulation) • Simulations have non-trivial computational requirements and their outcome is dependent of the particular portfolio characteristics used in the analysis

  20. Sector concentration • How to deal with sector concentration? • Some techniques have been developed trying to obtain a close-form solution for a multi-factor model, accepting a few simplifying assumptions • The idea is to model credit risk by a number of sectional factors common to all exposures within a sector and idiosyncratic component corresponding to each individual obligor • The model approximates the economic capital obtained with a full-blown multi-factor model • Two components: an extension of the economic capital based on the ASRF model • A multi-factor adjustment

  21. Sector concentration • How to deal with sector concentration? • With a few simplifying assumptions… • use sector averages instead of individual borrower PD, LGD and correlations • …it is even possible to focus only on the extension of the ASRF model (the first component) to obtain a reasonable approximation to economic capital • Thus, there are alternatives to intensive simulation-based assessments of economic capital

  22. Sector concentration • How to deal with sector concentration? • There are other approaches • Extensions of closed-form models • Binomial expansion technique (BET) by Moody’s • Infection models • A single-risk factor model with a scaling factor • The scaling factor is calibrated to the economic capital of a multi-factor model

  23. Stress testing • Development of stress testing techniques in the industry is still ongoing • Even more clear for stress testing concentration risk • Stress test should be plausible, consistent with the model framework and adapted to portfolio and internal reporting • Plausibility: credibility of the stress scenario • Consistency: use a credit portfolio model that is used by bank managers • Respect historical dependencies • Adapted: • focus on the sectors with the highest exposures or the highest correlations • Core factors vs. peripheral factors • Managers should be able to translate the results into concrete actions

  24. Conclusions • Concentration of credit portfolios is an important risk factor • It is currently subject to intensive modelling efforts • Name concentration is less relevant in terms of economic capital • However, sector concentration might have a significant impact of economic capital • Do not forget the traditional view on concentration risk • Experience from past banking crisis • Concentration is a worsening factor • Concentration in the own group is the riskiest factor

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