Because many books, scholars, bankers and regulators praise the advantages of diversification, it is a deliberate choice to start this section with the broader con- cepts of concentration, diversification and their challenges. Then, in section 3, an example of diversification will be taken with debt securities positions.
Every strategic plan confronts the challenge of top management policy torn between diversification and focus on a single product line. The choice a company’s
Chapter 8
169
board and CEO must make between diversification and concentration is neither an easy one nor are its consequences as clear-cut as they might seem to be. Indeed:
● Recent studies have cast doubt on the widely accepted notion that diversi- fication offers unquestionable benefits, and
● At the same time, the way in which most investors measure diversification through reference to broad industry sectors can be misleading.
Theoretically, concentrations of exposure in credit risk and in investment positions are two different issues. In practice, as we will see in this section and in section 3, the two share many common principles, as well as approaches to the control of exposure. Therefore, up to a point, the method used with one of them could be seen as a proxy for the other.
Also, theoretically, diversification is considered to be desirable because risk is spread over a wider landscape of lending and investment possibilities. In practice, this view ignores the fact that both the initial study and subsequent management of diversification engender their own types of risks – and sometimes these may be serious.
Imperfect diversification is one of these risks. In 2006, a Basel Committee Research Task Force did an excellent study on credit risk concentrations and the way they affect the portfolios of commercial banks. This study pointed out that risks may arise from two types of imperfect diversification:
● Name concentration
● Industry sector concentrations.
Name concentrations lead to specific risk and they occur because of large expos- ures to individual obligors. In the background of sector concentrations is imper- fect diversification across industry sector. (Both violate basic assumptions of the Asymptotic Single-Risk Factor (ASRF) model, underpinning regulatory capital calculations of the internal ratings-based (IRB) method of Basel II.) Name and sec- tor concentrations may be magnified by a third key exposure factor:
● Contagion risk.
Default contagion is the probability of an obligor’s default conditional on another counterparty defaulting (in mathematical logic this is known as Bayesian prob- ability, or abduction). Contagion risk can be seen as a halfway situation between name and sector concentration, with default dependency driven by close links between two obligors, which are not captured by the sector structure, leading to wrong-way risk.
Risk Accounting and Risk Management for Accountants
170
Ch08-H8422.qxd 7/4/07 4:37 PM Page 170
Contagion risk is created through exposures to independent obligors that exhibit greater default dependencies than might be expected from their sector affiliations.
These may, for instance, arise in the context of supply chain business intercon- nections or because of not-so-transparent correlations (Chapter 4).
Because concentration risk is very important, one might think that the financial industry has already developed appropriate tools and methods for its measure- ment and monitoring. The findings by the Basel Committee’s Research Task Force, as well as opinions expressed at a workshop it organized in November 2005, which involved supervisory, academic and industry participants, revealed that there is a great deal of diversity in the way banks measure and treat concentration risk:
● Some rely on simple ad hoc indicators of concentration risk and its likelihood
● Others (the more sophisticated) use portfolio credit risk models incorpor- ating interactions between different types of exposures.
The measures banks employ as regards concentration risk vary from one institution to the other. Generally, however, they include: an exposure limit system, eco- nomic capital models and tools allowing one to account for concentration risk in pricing new exposure. Some banks also use stress tests that include a concentra- tion risk component.
An interesting finding of the Basel Committee’s Research Task Force has been the patterns of asset correlations across and within sectors, which are basic deter- minants of credit concentration. The effects of name and sector concentrations, however, were found to be asymmetric, with sector concentrations being the more serious case. According to the published report:
● Name concentrations can add between 2% and 8% to credit value at risk
● The impact of sector concentrations is much more severe, and it can increase capital needs by 20–40%.1
Additionally, exposure associated with name concentration is better understood than industry sector concentration risk. This understanding is promoted by the fact that a number of analytical measurement tools exist for name concentrations, some of them based on ad hoc measures, while others employ credit risk models.
Another interesting finding by the Research Task Force is that commercial banks and supervisors do not necessarily have the same interpretation of concentrations and their risks. Supervisors interpret concentration risk as a deviation (plus or minus) from Basel II’s Pillar 1 minimum capital requirements. By contrast, credit institutions perceive that sector concentration, often referred to as diversification,
Chapter 8
171
warrants capital relief relative to Pillar 1, the latter being interpreted as the non- diversified benchmark of concentration exposure.