Managing Concentration Risk in Banking: Traditional Approaches and New Developments

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

3. 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

4. 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

5. 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

6. 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,…

7. 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

8. 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?

9. 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)

10. 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

11. 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)

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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,…)

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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