Analyzing concentration risk in credit portfolios

Concentration risk has been a core concern for credit portfolio managers for decades. It is well-known that concentration risk can lead to significant losses during volatile economic times due to correlated credit deterioration and defaults. This implies that these assets are not only correlated with the economy but also with each other, resulting in a higher risk of concentration and losses during times of stress. 

Managing the concentration risk of a credit portfolio is an essential component of a sound risk management process. One key finding from our analysis shows a capital relief of 21% when removing concentration impact. This also translates to a 21% chance of reducing the overall risk of the portfolio by managing concentration risk effectively. The quantification of concentration risk can help portfolio managers incorporate concentration impact into the risk-return profile of individual assets across various segments and design portfolio strategies aligned with the risk appetite framework.  

While concentration risk is inevitable for credit portfolios, it can be managed to maximize return-risk when proactively assessed and managed. 

This article discusses: 

• What is concentration risk? 
• How to quantify the impact of concentration risk? 
• How to utilize it for better strategic decisions? 

 

What is Concentration Risk? 

Concentration risk refers to the impact of common risk factors that can result in substantial losses to a segment of a credit portfolio. The Office of the Comptroller of the Currency (OCC) highlights in the Comptroller’s Handbook that excessive concentrations of credit have been key factors in banking crises and failures. The concentration for a credit portfolio arises primarily from two types of imperfect diversification: name concentration and sector concentration. 

 

Name Concentration 

Name concentration relates to imperfect diversification of idiosyncratic risk in the portfolio, either because of its small size or large exposures to specific individual obligors. For instance, material exposures to a few large names in the portfolio, such as Enron and WorldCom, led to a financial crisis for banks in the US in the early 2000s. 

 

Segment Concentration 

Segment concentration pertains to imperfect diversification across systematic components of risk, namely geography and industry factors. High concentrations in certain sectors, such as airlines and hotels, led to substantial losses during the pandemic for financial institutions with high concentrations in those sectors. 

Portfolio-level risk assessment is critical to risk management and risk-return analysis as it accounts for both the stand-alone credit risk of individual assets and the correlations of those assets, providing a true enterprise-level view of credit risk. By employing a correlation framework such as Moody’s GCORR, which is an extensive inter- and intra-asset class correlation model, one can incorporate granular and reliable correlations into portfolio credit risk assessments to capture the additional risk arising from name and sector concentrations. 

Basel II and Basel III also recognize the importance of correlations and concentration, stipulating that banks with different levels of concentration risk should have different levels of capital and cover concentration risk explicitly under the Internal Capital Adequacy Assessment Process (ICAAP). Once concentration risk is captured in the overall portfolio risk metrics, the next step is to understand what drives the name or segment concentration and the magnitude of the impact to manage and reduce concentration risk through portfolio strategies effectively. 

 

How to Quantify the Impact of Concentration Risk? 

When correlations are employed in portfolio credit risk assessments, the risk of an individual asset is captured through systematic risk and idiosyncratic risk: 

• Systematic Risk: The risk in common with other firms due to the state of the economy, which is undiversifiable. 
• Idiosyncratic Risk: The net of the systematic risk or firm-specific risk that is diversifiable. 

 

Two firms with the same systematic risk will be similarly affected by a shock to the common systematic risk, while their idiosyncratic risk would always be unique to each firm. In Moody’s GCORR framework, systematic risk is defined as geography, industry, property type, or product type. 

 

Quantifying Name Concentration 

Name concentration arises when a portfolio contains large, single-name exposure where returns on individual exposures are more heavily correlated. In a portfolio where 10% of the total exposure is attributed to a single name, a significant shock to this name could affect at least 10% of the portfolio. The key to quantifying name concentration is the firm-specific or idiosyncratic risk. If the large, single name is broken up into smaller and less concentrated names with the same risk profiles and the same systematic risk exposure, they will have the same systematic risk but may not default all at once due to each name’s unique idiosyncratic shocks. This reduces the probability of large losses compared to having one large name with the same total exposure amount. If the collection of these names continues to be broken into an infinitely granular portfolio, the idiosyncratic component is eventually fully diversified. This is how name concentration is quantified: by comparing portfolio risk with full idiosyncratic risk of individual names and without idiosyncratic risk while maintaining the same level of systematic risk. 

 

Quantifying Segment Concentration 

Like name concentration, a high exposure to one sector or one geography could lead to extreme losses if there were a shock to the segment. Once the name concentration is removed, the segment concentration can be assessed and quantified. Each segment’s concentration risk can be reassessed by removing the segment (i.e., industry or geography), and the new portfolio risk is compared to the original portfolio risk without name concentration to quantify the incremental impact of each segment’s concentration risk. 

 

Case Study 

Consider three portfolios, A, B, and C, all constructed to have the same total dollar exposures. Both A and B have ten unique industries, but Portfolio B has the dollar exposure more equally distributed across the industries. Portfolio C contains 25 equally weighted industries. 

 

Figure 1: Portfolio Composition 

Leveraging the framework discussed above, the name and segment concentrations can be decomposed for each portfolio. The name concentration is assessed first, and then each segment is quantified afterward. 

Figure 2: Name and Industry Concentration Analysis 

Key findings here are:

1. 1. Despite the same total exposure amount, Portfolio A has the highest portfolio risk or tail risk (i.e., economic capital) due to its high name and segment concentration. Portfolio A also has the highest name and segment concentration levels compared to Portfolios B and C. 
2. 2. Portfolio B, despite having the same number of industries, with a more equal distribution of the exposure amount across the names, has a smaller total portfolio risk than Portfolio A. Portfolio B also has a smaller level of name concentration. 
3. 3. Portfolio C, where there are more industries and less dollar concentration for each name, has the smallest total portfolio risk as expected, and both segment and name concentrations are much smaller. 

This case study demonstrates the importance of concentration management and diversification to not only reduce portfolio risk but also reduce name or segment concentration. 

How to Utilize Concentration Analysis? 

The same framework can be applied to quantify the concentration risk for each name and each segment. This can be leveraged for various use cases.

 

Regulatory Needs 

Concentration is one of the focused areas of regulators around the world. Due to the standardized nature of regulatory capital, regulators emphasize each bank’s responsibility to measure, monitor, and control its credit risk concentrations explicitly concerning capital adequacy under Pillar 2. Notable regulators such as the EBA, ECA, OSFI, OCC, etc., expect financial institutions to implement appropriate methodologies and practices in line with their risk policy to aggregate the credit risk in portfolios, segments, business lines, or names for credit risk concentration and apply it to risk management practice and new business strategies. 

 

Business Needs 

This exercise allows portfolio managers to better understand which name or which segment has the highest incremental risk impact on the portfolio even if the names or segments have the same risk profile. Depending on the size and level of correlations, each name and segment can have different levels of concentration risk. This will help portfolio managers make strategic decisions as to which name or segment exposures could be added to be most beneficial to the portfolio.  

By knowing where the highest diversification benefit or worst concentration risk lies, one can effectively manage risk and, in turn, improve the return-risk ratio. Looking at the portfolio before and after the name concentration, one can see less variability in the risk-return across exposures while the risk-return ratio (described as Vasicek or VR ratio) also increases for the portfolio. 

 

Figure 3: Profitability after Name Concentration