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# Concentration risk

Concentration risk is a banking term describing the level of risk in a bank's portfolio arising from concentration to a single counterparty, sector or country.

The risk arises from the observation that more concentrated portfolios are less diverse and therefore the returns on the underlying assets are more correlated.

Concentration risk can be calculated for a single bank loan or whole portfolio using a "concentration ratio". For a single loan, the concentration ratio is simply the proportion of the portfolio the loan represents (e.g. a \$100 loan in a \$1000 portfolio would have a ratio of 0.1 or 10%)

For a whole portfolio, a herfindahl index is used to calculate the degree of concentration to a single name, sector of the economy or country. Separate concentration ratios must be calculated for each type of concentration.

To illustrate, a portfolio with 10 equally sized loans would have a concentration ratio of 0.1 or 10%, whereas a portfolio of 10 loans - 9 equally sized and 1 equal to half the value of the portfolio would have a concentration ratio of 0.27 or 27%.

The ratio is useful for bankers or investors at large to identify when a portfolio may be excessively exposed to the risk that a recession or downturn in one sector of the economy or another country may cause a high proportion of the bank's outstanding loans to default.

Concentration risk is usually monitored by risk functions, committees and boards within commercial banks and is normally only allowed to operate within proscribed limits. It is also monitored by banking regulators and generally attracts a higher capital charge in banking regulation.

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• ✪ What is Concentration Risk?
• ✪ Portfolio Diversification vs. Concentration
• ✪ Financial Markets and Institutions - Lecture 46b - COURSE COMPLETE

#### Transcription

Welcome to the Investors Trading Academy talking glossary of financial terms and events. Our word of the day is “Concentration Risk” Concentration risk is the risk posed to a financial institution by any single or group of exposures which have the potential to produce losses large enough to threaten the ability of the institution to continue operating as a going concern. In other words, it's the opposite of a diversified portfolio. For example, an institution may have a concentration of loans in a certain geographic area. If that area experienced an economic downturn an unexpected volume of defaults might occur, which could result in significant losses to or failure of the institution. Or an institution may have a concentration in a certain type of lending, for example construction lending. If construction slows unexpectedly, the impact to the institution could be significant. By their very nature community banks and credit unions have some degree of concentration risk; geographically, within their customer/member base, and by products they specialize in and offer. The smaller the geographic area served, the more limited the customer base is, and the fewer number of products offered all lead to increased concentration risk. Concentrations can also exist in asset categories, such as residential real estate, automobiles, business loans within asset categories, such as junior position home equity lines of credit within a residential category, indirect auto loans within an automobile category, or SBA loans within a business loans category, or as loan quality rating categories, such as a concentration of lower quality credits (loans). Lastly, concentrations can exist in seemingly unrelated categories. A classic example is a financial institution that invests in mortgage back securities in its investment portfolio, while at the same time investing in mortgage loans in its loan portfolio.

## Types

There are two types of concentration risk. These types are based on the sources of the risk. Concentration risk can arise from uneven distribution of exposures (or loan) to its borrowers. Such a risk is called name concentration risk. Another type is sectoral concentration risk, which can arise from uneven distribution of exposures to particular sectors, regions, industries or products.[1]

## Monitoring and management

Most financial institutions have policies to identify and limit concentration risk. This typically involves setting certain thresholds for various types of risk. Once these thresholds are set, they are managed by frequent and diligent reporting to assess concentration areas and identify elevated thresholds.[2]

A key component to the management of concentration risk is accurately defining thresholds across various concentrations to minimize the combined risks across concentrations.

## References

1. ^ "Concentration Risk". Visible Equity. Archived from the original on December 6, 2013.
2. ^ "Principles for the Management of Concentration Risk" (PDF). Malta Financial Services Authority. 2010.