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Sector Concentration in Loan Portfolios and Economic Capital

Author

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  • Klaus Düllmann

    () (Deutsche Bundesbank)

  • Nancy Masschelein

    () (NBB, Department of International cooperation and Financial Stability)

Abstract

The purpose of this paper is to measure the potential impact of business-sector concentration on economic capital for loan portfolios and to explore a tractable model for its measurement. The empirical part evaluates the increase in economic capital in a multi-factor asset value model for portfolios with increasing sector concentration. The sector composition is based on credit information from the German central credit register. Finding that business sector concentration can substantially increase economic capital, the theoretical part of the paper explores whether this risk can be measured by a tractable model that avoids Monte Carlo simulations. We analyze a simplified version of the analytic value-at-risk approximation developed by Pykhtin (2004), which only requires risk parameters on a sector level. Sensitivity analyses with various input parameters show that the analytic approximation formulae perform well in approximating economic capital for portfolios which are homogeneous on a sector level in terms of PD and exposure size. Furthermore, we explore the robustness of our results for portfolios which are heterogeneous in terms of these two characteristics. We find that low granularity ceteris paribus causes the analytic approximation formulae to underestimate economic capital, whereas heterogeneity in individual PDs causes overestimation. Indicative results imply that in typical credit portfolios, PD heterogeneity will at least compensate for the granularity effect. This suggests that the analytic approximations estimate economic capital reasonably well and/or err on the conservative side.

Suggested Citation

  • Klaus Düllmann & Nancy Masschelein, 2006. "Sector Concentration in Loan Portfolios and Economic Capital," Working Paper Research 105, National Bank of Belgium.
  • Handle: RePEc:nbb:reswpp:200611-17
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    File URL: https://www.nbb.be/doc/oc/repec/reswpp/wp105.pdf
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    References listed on IDEAS

    as
    1. Gordy, Michael B., 2000. "A comparative anatomy of credit risk models," Journal of Banking & Finance, Elsevier, vol. 24(1-2), pages 119-149, January.
    2. Lopez, Jose A., 2004. "The empirical relationship between average asset correlation, firm probability of default, and asset size," Journal of Financial Intermediation, Elsevier, vol. 13(2), pages 265-283, April.
    3. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-470, May.
    4. Gourieroux, C. & Laurent, J. P. & Scaillet, O., 2000. "Sensitivity analysis of Values at Risk," Journal of Empirical Finance, Elsevier, vol. 7(3-4), pages 225-245, November.
    5. M. Hashem Pesaran & Til Schuermann & Björn-Jakob Treutler, 2005. "The Role of Industry, Geography and Firm Heterogeneity in Credit Risk Diversification," IEPR Working Papers 05.25, Institute of Economic Policy Research (IEPR).
    6. Dietsch, Michel & Petey, Joel, 2002. "The credit risk in SME loans portfolios: Modeling issues, pricing, and capital requirements," Journal of Banking & Finance, Elsevier, vol. 26(2-3), pages 303-322, March.
    7. Gordy, Michael B., 2003. "A risk-factor model foundation for ratings-based bank capital rules," Journal of Financial Intermediation, Elsevier, vol. 12(3), pages 199-232, July.
    8. Lutz Hahnenstein, 2004. "Calibrating the CreditMetrics™ correlation concept — Empirical evidence from Germany," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 18(4), pages 358-381, December.
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    More about this item

    Keywords

    sector concentration risk; economic capital;

    JEL classification:

    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • C1 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General

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