Concentration Risk in Credit Portfolios and Its Treatment Under Basel II

Banks often only look at one side of concentration risk – the diversification effect. Thus, it is often argued that the requirements of Pillar 1 are the non-diversified benchmark and therefore an upper barrier for the true capital requirement. But as the Basel II formulas have been calibrated on well-diversified portfolios with low name and low sector concentrations, it is indeed possible that banks should have an additional capital buffer to capture concentration risk. Furthermore, some theoretical models as well as empirical studies have demonstrated that concentrated banks can be less risky than diversified banks, which is mainly due to better monitoring abilities of specialized financial institutions. However, even if it can be economically reasonable to be focused on particular industry sectors or geographical regions, the capital requirements should still be higher than for diversified banks. The main argument is that although a specialized bank could benefit from the ability to invest in firms with higher quality (of course it is not even clear that a higher risk-return premium is earned through lower risk), the bank would still be very vulnerable if the specific sector is in an economic downturn scenario. But exactly such a downturn scenario, often quantified with the VaR, plays the decisive role for the capital requirements.