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Sector concentration in loan portfolios and economic capital

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  • Masschelein, Nancy
  • Düllmann, Klaus

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

  • Masschelein, Nancy & Düllmann, Klaus, 2006. "Sector concentration in loan portfolios and economic capital," Discussion Paper Series 2: Banking and Financial Studies 2006,09, Deutsche Bundesbank.
  • Handle: RePEc:zbw:bubdp2:5156
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    References listed on IDEAS

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    1. 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).
    2. 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.
    3. 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.
    4. 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.
    5. 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.
    6. 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.
    7. Krüger, Ulrich & Stötzel, Martin & Trück, Stefan, 2005. "Time series properties of a rating system based on financial ratios," Discussion Paper Series 2: Banking and Financial Studies 2005,14, Deutsche Bundesbank.
    8. Gordy, Michael B., 2000. "A comparative anatomy of credit risk models," Journal of Banking & Finance, Elsevier, vol. 24(1-2), pages 119-149, January.
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    Citations

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    Cited by:

    1. Sokolov, Yuri, 2009. "Interaction between market and credit risk: Focus on the endogeneity of aggregate risk," MPRA Paper 18245, University Library of Munich, Germany.
    2. Nikola Tarashev & Haibin Zhu, 2008. "Specification and Calibration Errors in Measures of Portfolio Credit Risk: The Case of the ASRF Model," International Journal of Central Banking, International Journal of Central Banking, vol. 4(2), pages 129-173, June.
    3. Mager, Ferdinand & Schmieder, Christian, 2008. "Stress testing of real credit portfolios," Discussion Paper Series 2: Banking and Financial Studies 2008,17, Deutsche Bundesbank.

    More about this item

    Keywords

    sector concentration risk; economic capital;

    JEL classification:

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

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