Understanding and Managing Credit Concentration Risk in Business Portfolios

“Don’t put all your eggs in one basket” applies equally to business portfolios. Focusing solely on revenue, supply, credit or any other key risk areas can have catastrophic results for any organization.

Smart businesses have implemented policies and monitoring tools to protect themselves against excessive concentrations of risk. This typically means setting and adhering to concentration risk limits that incorporate multiple criteria.

1. Identifying High-Risk Accounts

Monitoring risk levels is one of the cornerstones of effectively managing credit concentration risk. Alerts such as those provided by Experian BusinessIQ provide proactive monitoring portfolio accounts, notifying of notifications that help keep risks under control and help keep risk under management.

The board should develop a policy on concentration risk that articulates its philosophy, sets acceptable limits commensurate with net worth targets, and offers rationale as to why such limits should exist. Furthermore, periodic reporting should take place against parameters established by the board.

Concentrations risks in segments and/or business lines are exposed to market forces that magnify credit risk and other concentration risks. For instance, significant exposure to construction and development loans (C&D) at the peak of the real estate bubble could amplify defaults when housing prices begin declining; similarly, loans to specific sectors or individuals within an economy could magnify exposures when industry difficulties arise.

2. Monitoring High-Risk Accounts

As part of Pillar 2 of the risk-based capital adequacy standard, credit unions must demonstrate they conduct an assessment of concentration risk in their business portfolios and document an appropriate level. Scenario and sensitivity analyses must match the size, complexity, and risk characteristics of portfolio segments or product offerings being evaluated.

Automated tools designed to monitor portfolio trends over time can help your institution identify and respond more swiftly to risks, potentially saving it from unnecessarily increasing exposures and incurring financial losses as a result of unnecessary concentration of exposures. The best tools offer clear visibility with alerts that notify when accounts approach predefined thresholds.

Management at a credit union must implement an internal rating system for residential real estate loans, member business loans, loan participations and asset/liability management (ALM) investments. This rating system should adhere to sound credit evaluation criteria and be regularly audited by an outside entity.

3. Managing High-Risk Accounts

Concentration risks require robust processes to identify, monitor and control them. According to the OCC’s reports on bank crises and failures, excessive concentrations in credit portfolios have often been the root cause. Common forms of concentration include name concentration and segmentation concentration which both result from imperfect diversification between idiosyncratic and systematic risk components.

Credit unions may target certain business accounts based on collateral type (e.g. commercial real estate and MBLs), lien position, non-traditional terms like interest-only payments and balloon payments or loan to value ratio. Or they might focus their portfolios on loans from certain segments that could be vulnerable to protracted economic slowdowns.

Establishing an efficient monitoring process with an accurate risk rating system is paramount to successful management of concentration risk at an enterprise-wide level and should be regularly evaluated against peer analyses for comparison purposes. Doing this allows organizations to take proactive steps toward mitigating concentration risk effectively.

4. Reducing High-Risk Accounts

Once appropriate systems have been put in place, monitoring and controlling concentration risk should become part of routine senior management functions, with ultimate responsibility residing with the board. Regular formal reporting to the board on concentration risk should be required depending on its size, complexity and risk exposure of portfolio or business line being managed.

An effective, accurate, and timely risk rating system must be put in place for every business portfolio containing loan participations. This rating system should utilize credit scores to accurately evaluate client performance over time (e.g. aging and payment patterns) as well as score-based segmentation strategies that reduce concentration risk at both account and portfolio levels – helping your institution attain increased return with less risk – thus creating the basis for a sustainable business model.