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Sector concentration in loan portfolios and economic capital

  • Masschelein, Nancy
  • Düllmann, Klaus
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    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.

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    Paper provided by Deutsche Bundesbank, Research Centre in its series Discussion Paper Series 2: Banking and Financial Studies with number 2006,09.

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    Date of creation: 2006
    Date of revision:
    Handle: RePEc:zbw:bubdp2:5156
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    1. Christian Gourieroux & J. P. Laurent & Olivier Scaillet, 2000. "Sensitivity Analysis of Values at Risk," Econometric Society World Congress 2000 Contributed Papers 0162, Econometric Society.
    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. 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.
    4. Jose A. Lopez, 2002. "The empirical relationship between average asset correlation, firm probability of default and asset size," Working Paper Series 2002-05, Federal Reserve Bank of San Francisco.
    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. Christian Gourieroux & Jean-Paul Laurent & Olivier Scaillet, 2000. "Sensitivity Analysis of Values at Risk," Working Papers 2000-05, Centre de Recherche en Economie et Statistique.
    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, Research Centre.
    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.
    9. Merton, Robert C., 1973. "On the pricing of corporate debt: the risk structure of interest rates," Working papers 684-73., Massachusetts Institute of Technology (MIT), Sloan School of Management.
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