Concentration Risk in
Small States
18th April 2011
Claudia Rausi
Was the crisis a result of Leverage and
Concentration?
Lehman - MBS and commercial real estate
Northern Rock - Concentration in funding from the
wholesale market
Wachovia - Concentration in California real estate
AIG - Concentrations in CDS
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What is Concentration Risk?
Exposures with the potential to produce losses large
enough to threaten the financial institution’s health,
soundness, its ability to maintain its core operations or
exposure that result in a change in risk profile.
Traditionally applied to credit exposures.
It now extends to interrelated assets & liabilities across
markets, sectors, countries, and economic activity.
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What causes Concentration?
Strategy - Concentrated by area, product or market.
Specific cycles, business and geographic specialization
may still enhance performance.
Correlations behave different from benign conditions,
hence stress testing reveals concentrations.
Inter-relationships between different risks not readily
apparent or identifiable.
Concentrated in its earnings structure ex business sector.
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Basel Framework
Pillar 1 capital provisions assumes that Credit Risk is
perfectly diversified.
Concentration is dealt with under Pillar 2.
Any additional capital allocated after measures aimed at
mitigating concentration risk.
Additional focus on Large exposure to a single group or
group of connected clients.
Principle of Proportionality.
Gap analysis and Implementation Plans
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Two-fold type of risk
Intra-risk analysis - the risk arising from interactions
between exposures within a single category. It is already
captured by internal models ex VAR.
Inter-risk analysis - identify and assess all risk
concentrations as a single risk event. Risks arising from a
common risk driver or interacting risk drivers.
Irrespective of where exposure are booked whether
Banking and Trading
Arises “simultaneously” or “successively”
Affects capital, liquidity and earnings.
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Diversification Benefits
Diversification reduces idiosyncratic risk but not
systemic risk.
Diversification benefits are acknowledged in Pillar 1,
particularly under Advanced Approach.
Asset correlation are not stable and in distressed
conditions may approximate one (perfect correlation).
Diversification effects between market and credit risk,
should be regarded with great caution if they are not
derived from an integrated approach. Therefore,
exercise caution.
Inter-risk diversification benefits accepted only
after in-depth supervisory review.
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Risk Management Process
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Principles for Managing Concentration
Risk
Develop policies and procedures aimed at identifying,
measuring, managing, monitoring & reporting
Concentration Risk. Examine how it derives from the
Business Model and assign tolerance levels that fit within
the Risk Appetite.
Have an integrated approach. Do not aggregate by simply
summing up due to interrelations.
Identify Risk Drivers that apply on- and off-balance sheet
and committed and uncommitted exposures for IntraExposure and Inter-Risk Exposures. Done through
adequate data systems to go beyond first-order
observations ie Stress Tests and Sensitivity Analysis.
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Principles for Managing Concentration
Risk (2)
A Framework to measure concentration frequently and
timely including its impact on profitability, solvency, and
liquidity. Include multiple methods such as scenario
analysis to be forward looking.
Have internal limits and thresholds to control, monitor
and mitigate undesired concentrations through top-down
limits to counterparties, connected CP, sectors or
industries, products, countries between different risk
factors. Undertake regular analysis.
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Principles for Managing Concentration
Risk (3)
Assess the amount of capital when undertaking Capital
Planning. It may not always be possible to explicitly
allocate for concentration risk.
Credit Intra-Risk - define concentration to counterparties,
connected counterparties, economic sectors, country, same
activity, credit risk mitigation. Models should capture
borrower interdependencies.
Models parameters per se may affect results. Ex. SME or
Retail, data may not be available. Assumptions might be
easily violated.
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Principles for Managing Concentration
Risk (4)
Market Intra-Risk - assess the value of the portfolio under
stress testing and sensitivity analysis as correlations
change under distress, and under non-linear effects.
Valuation methodologies make it as more arduous task.
Operational Intra-Risk refers to any single operational
risk with the potential to produce large enough losses
that affect the institution’s financial health.
Ex settlements function or dependency on few
suppliers/providers for core functions. LFHI risks (low
frequency high impact) may be included. Analysis of
patterns of frequency and severity loss data can reveal
major risk drivers and effects.
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Principles for Managing Concentration
Risk (5)
Incorporate the potential affects of illiquidity of the
market.
In funding, concentration exists if the institution is
vulnerable to a single factor such as a run off on deposits
or inadequate access to new funding.
Concentration may occur in Maturity of funding, such as
excessive over-reliance on short term to finance long
term mortgages. Have liquidity ratios to flag early
concentrations ex. Wholesale funding ratio, Top 10
Deposits.
Contingency funding plans such as Liquidity buffers to
mitigate any unmitigated concentration.
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Regular Reviews
Undertake a thorough sector risk review
Review with greater intensity the economic performance of existing
borrowers.
Review approval levels for business.
Review risk mitigation techniques, their value and their legal
enforceability.
Review outsourced activities and contracts signed with third parties
(vendors) particularly for core operations.
Review the funding strategy, so as to ensure the maintenance of an
effective diversification in the sources and tenor of funding.
Assess the business strategy.
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Mitigating Actions
Reduce limits or thresholds on risk concentrations.
Adjust the business strategy to address undue
concentrations.
Diversify the asset allocation or funding structure.
Buying protection from other parties (e. g. credit
derivatives, collateral, guarantees and sub-participation).
Selling certain assets.
Change outsourcing arrangements.
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Other Mitigants
Reduce limits to funding from inter-bank markets.
Reduce limits related to maximum or minimum average
maturities.
Reduce limits concerning maturity mismatches
Reduce limits for off-balance sheet positions.
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Risk Management Tools
Qualitative vs. Internal Measurement Models
Principle of Proportionality i.e. nature, scale, complexity, size,
systemic importance ex concentration in business lines,
products or geographic due to expertise in the market.
Requires a balanced view.
Method of aggregation, Summation, VAR, copulas
Herfindahl Hirschman Index HHI
Gini Coefficients and Lorenz Curves
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Gini Coefficient
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Other considerations
Make sure that return is commensurate to the risks.
Adopt a Portfolio Based Approach.
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