Concentration risk
| Concentration risk |
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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.
Examples of Concentration risk
- Credit Risk: Credit risk is the risk that a borrower or counterparty will default on its financial obligations. It can arise when dealing with customers, counterparties or suppliers. Credit risk can be mitigated through diversification, hedging, and setting appropriate credit limits.
- Market Risk: Market risk is the risk that the value of an investment will decline due to fluctuations in the market. It is usually caused by changes in the price of a security or an index. Market risk can be managed by diversifying investments, hedging, and monitoring the market for potential changes.
- Counterparty Risk: Counterparty risk is the risk that a counterparty will default on its contractual obligations. It can arise from derivatives, bonds, loans, corporate actions, and other financial instruments. Counterparty risk can be managed by monitoring counterparties, setting appropriate credit limits, and hedging against potential losses.
- Operational Risk: Operational risk is the risk of loss due to inadequate or failed internal processes, people, and systems. It can arise from errors, fraud, or external events. Operational risk can be managed by implementing proper controls, training staff, and monitoring systems.
- Liquidity Risk: Liquidity risk is the risk that an institution will be unable to meet its financial obligations due to a lack of liquidity. It can arise from a lack of cash or cash equivalents, or from an inability to convert assets into cash quickly enough. Liquidity risk can be managed by monitoring cash flow, maintaining adequate liquidity buffers, and having access to external sources of funding.
Advantages of Concentration risk
Concentration risk has a number of advantages. Firstly, it allows an institution or investor to benefit from their specialized knowledge of their counterparties. This can lead to higher profits, as the institution can leverage their knowledge to better manage the risks and rewards associated with the investments. Secondly, it allows the institution or investor to have a higher degree of control over their investments, as they can be more proactive in managing the associated risks. Finally, it can lead to cost savings, as the institution or investor can reduce the costs associated with diversifying their portfolio. *In summary, concentration risk offers increased control and potential cost savings, whilst allowing the institution or investor to benefit from their specialized knowledge of their counterparties.
Limitations of Concentration risk
Concentration risk can be a serious threat to the financial health of an organisation, however there are certain limitations associated with it. These include:
- Lack of proper assessment of the risks: It is essential to evaluate the potential losses associated with concentration risk in order to take appropriate corrective measures. Without proper assessment of the risks, it is difficult to manage and mitigate them.
- Difficulty in measuring the degree of concentration: Concentration risk is difficult to measure and quantify as it is based on assumptions and estimates.
- Challenges in diversifying the portfolio: It is often difficult to diversify the portfolio due to the limited number of counterparties available.
- Difficulty in predicting the future: As concentration risk is based on assumptions and estimates, it is difficult to predict the future and take preventive measures.
- Potential for significant losses: Since the concentration risk is not easy to manage, there is a possibility of significant losses in case of an unexpected event.
One of the other approaches related to concentration risk is diversification, which involves spreading assets across different investments to reduce risk or maximize return. Other approaches include:
- Stress testing - It is a method used to assess a portfolio’s exposure to potential losses in value due to shocks in the market. Stress testing helps to identify concentration risk and potential losses in value.
- Risk management - Risk management is a process of identifying and managing potential risks that could affect an institution’s financial health. It helps to identify and manage exposure to concentration risk.
- Hedging - Hedging is a strategy used to protect an institution’s investments from losses due to market volatility. Through hedging, an institution can offset the losses due to concentration risk.
- Credit monitoring - Credit monitoring is a process of monitoring the creditworthiness of counterparties and customers. This helps to identify and manage concentration risk in a portfolio.
In summary, there are various approaches to managing concentration risk, such as diversification, stress testing, risk management, hedging, and credit monitoring. These strategies help to identify and manage exposure to concentration risk.
References
- Ávila F., (2019). Concentration indicators: Assessing the gap between aggregate and detailed data
- Christodoulakis G., (2017). The Analytics of Risk Model Validation, Elsevier
- Grippa P., (2016). Measuring Concentration Risk - A Partial Portfolio Approach, International Monetary Fund
- Horcher K. (2011). Essentials of Financial Risk Management, John Wiley & Sons
- Hibbeln M., (2010). Risk Management in Credit Portfolios: Concentration Risk and Basel II, Springer Science & Business Media
- Lotti L., (2019). Concentration risk
- The Joint Forum, (2019). Risk concentration principles
Author: Izabela Stań
