Concentration risk

Concentration risk
See also

Concentration risk is understood as the potential for a loss in value of a financial institution or an investment portfolio caused by exposure to a particular group of counterparties. The loss can seriously threaten an organisation's financial health and if it happens, recovery might be even impossible. In such a case the portfolio will be either liquidated or the institution will go bankrupt. It is worth noticing that even though the concentration risk emphasizes a negative aspect of the concentration, higher exposure to particular counterparties doesn't automatically require an implementation of diversification strategy. Such companies usually have detailed and specialized knowledge about the counterparties and know how to react appropriately in firm-specific situations. (M. Hibbeln 2010, s. 57-60)

Types of risk concentration

Depending on factors, on which the company can be exposed, risk concentration is usually distinguished between four categories (M. Hibbeln 2010, s. 57-59):

  • Market risk relates to a concentration in currency
  • Liquidity risk is an exposure to refinancing counterparties
  • Operation risk relates to company's dependence from IT-systems
  • Credit risk does not only relate to too high, uneven loan allowance for a particular client or a group of clients, but the term has extended its meaning in recent years and currently covers broader portfolio diversification risk as well.

Within credit risk, the following three subcategories can be distinguished:

  • Name concentration is an exposure to either one company or a conglomerate of a few highly dependent on each other firms'
  • Sector concentration, which is an uneven exposure to particular regions, products or sectors. A default might occur by some underlying factors such as geographical location
  • Credit contagion can occur by two or three companies having business connections, which significantly increases a conjoint propability of a default.

Techniques of monitoring company's credit exposure

Credit exposure is usually unavoidable. There are, however, some general techniques, which help to manage company's credit exposure in a conscious way (K. Horcher 2019):

  • Focus mainly on high-quality counterparties
  • Require trustworthy payment techniques and settlement
  • Formalize credit risk function
  • Constantly monitor market value of outstanding contacts
  • Opt for netting agreements when it is possible

Principles of risk concentration

There are several principles that should be taken into consideration by companies' managers by risk concentration. They can significantly reduce its threats for a firm. (Risk Concentrations Principles, 2011)

  • Managers should deal appropriately with material risk concentrations, which have a significant impact on regulated entities.
  • Managers should continuously manage material risk concentrations for instance through regular reports to help understand risk concentrations of financial conglomerates accurately.
  • Managers should cooperate to share concerns and act accordingly.
  • Managers should provide that conglomerates have adequate risk management processes to manage group-wide risk concentrations. If it is necessary, they should put additional effort to ensure that.

References

Author: Izabela Stań