Studies on credit risk concentration: an overview of the issues and a synopsis of the results from the Research Task Force project

Historical experience shows that concentration of credit risk in asset portfolios has been one of the major causes of bank distress. This is true both for individual institutions as well as banking systems at large. It is therefore important to measure concentration risk in credit portfolios of banks that arises from two sources, systematic and idiosyncratic. Systematic risk represents the effect of unexpected changes in macroeconomic and financial market conditions on the performance of borrowers. Idiosyncratic risk represents the effects of risks that are peculiar to individual firms. The model framework for the internal ratings-based (IRB) approach of the Basel II Framework assumes that (a) there is only a single source of systematic risk, and (b) bank portfolios are perfectly fine-grained in the sense that as the largest individual exposures account for a smaller and smaller share of total portfolio exposure, idiosyncratic risk is diversified away at the portfolio level. To the extent that either assumption is violated, IRB capital requirements may understate the true economic capital requirement. The Concentration Risk Group of the Research Task Force of the Basel Committee on Banking Supervision undertook a principally analytical project with the following objectives: (i) to provide an overview of the issues and current practice in a sample of the more advanced banks as well as highlight the main policy issues that arise in this context; (ii) to assess the extent to which "real world" deviations from the "stylised world" behind the assumptions of the IRB model can result in important deviations of economic capital from Pillar¿1 capital charges in the IRB approach; and (iii) to examine and further develop fit-for-purpose tools that can be used in the quantification of concentration risk. This paper provides an overview of the work conducted by this group and its findings. The various methodologies for the treatment of concentration risk which were analysed or refined by the group aim to reflect the current state of research in the industry and in academia.