Concentrating on Concentration Risk
Senior economists such as Ben Bernanke were still studying the Great 30s Depression when the financial crisis struck in full force circa 2007. Given the complexity of the modern economic and financial landscape compared to the blessed good old days - we have no reports of FWMD (financial weapons of mass destruction) from back then - we can reasonably project that economists will be studying and pontificating on causes and remedies for the current crisis for the next 100 years or so
What are we - mere mortal - risk managers to do in the meantime? How to navigate this maelstrom of regulatory, if not conceptual, confusion and uncertainty?
The answer is, we believe, to chart the broadest outline the current situation and then act accordingly with the needs of the nature of each major problem area. In this big picture approach there are at least two major scenes where the cinders from the volcanic explosion that was the recent crisis are still smoldering. These areas are still traumatized and need to heal before anything new can grow there. They draw full attention anyway, therefore we will only sketch their outline here:
- The first toxic zone is the severe challenge to the moral standing of the financial industry, as exemplified by a long string of fiascoes and fines. This lethal terrain is way beyond just a simple risk management issue and is an existential threat for the entire industry
- The second toxic zone is any topic touching on leverage and required capital at the macro level. Regulatory measures to date have hurriedly and pragmatically tried to remedy the situation, but the implications, consistency, workability and durability of choices, measures and methodology remains to be seen
It is a legitimate question if there is anything left to work on if we exclude the above two intensive care areas. Does it even make sense to make room for any additional agenda items? Well, we think the answer is a resounding yes, because:
The raison-d'etre of the financial industry is to provide the technology for accurate and efficient low level assessment and management of risks
The important macro stability and culture issues will have to be resolved one way or the other, but they primarily enable rather than improve a firm’s ability to execute its core mission. The danger is that fundamental technical capabilities and know-how for managing specific risks face degeneration and atrophy as they are deemed non-central in the current struggle to survive.
The threat to sleepwalk into an unworkable state is beautifully exemplified by the transformation already undergoing in the so called Pillar II area, where banks are supposed to evaluate their own material risks and discuss them with their regulators under the ICAAP/SREP processes. Very interesting developments in this respect (in the European context) are the latest EBA guidance and the PRA consultation paper. Even while internal tools and practices face a credibility challenge, it is at the same time clear that they are not optional and there are no easy alternatives.
One prominent such low level capability is the identification and measurement of credit concentration risk. Credit concentrations can take many forms and can overlap in non-trivial ways. The state of the art in identifying and measuring (let alone managing) credit concentration risk is today, alas, not much further than a decade ago. Here is a very brief review of some obvious weaknesses:
- Name concentration is a famous and much discussed category in light of the simplifications of the A-IRB capital formula. There is even a certain amount of complacency based on the perceived adequacy of (admittedly brilliant) approximations such as the Granularity Adjustment. Yet even for this most understood of concentration risks it is not clear for example what is a realistic benchmark portfolio and whether it should be the same in all jurisdictions
- Around sector / geographic concentrations there is an almost a universal reliance on a correlation matrix approach. Yet there is a white elephant in the room. Actually many white elephants. They go under the name of sovereign risks. Geographic risks are not following the cyclical downturns of business sectors within the same region. Instead they manifest as contagion cascades with longer gestation periods and more disastrous outcomes when they happen. Standard portfolio models are manifestly unable to capture the complicated tail phenomena that these cascades produce
- There is an another category, loosely defined as product concentration risk which does not fit neatly in any matrix and overlaps inconveniently with many other risks. So the category appears and disappears randomly from regulatory frameworks, depending maybe on perceived regulatory fatigue. But awkward categorization does not make this less of a real and present danger. Do you need a pressing example? It is neatly provided by the FWMD named Foreign currency denominated mortgage
The next installment is a course dedicated in particular to the discussion of the BOE/PRA benchmark methodologies for credit concentration. This focus was spurred and motivated by the PRA’s decision to make public a set of benchmark methodologies for credit concentration capital add-ons, which is a significant first.
If you are interested in credit concentration risk we would like to invite you to join the discussion. It might not be your biggest problem right now, but chances are it will be in the future!