Sector Concentration
From Open Risk Manual
Definition
Sector concentration is a form of Credit Risk Concentration. It arises when a material share of a Credit Portfolio is allocated to
- a single Business Sector or
- a group of related sectors linked by strong economic ties
Usage
What constitutes a "material share" of the portfolio must be defined in context: For example in relation to total assets, to available risk capital etc.
Sector concentration depends on various characteristics of the portfolio:
- the number of sectors represented in the portfolio (the concentration risk is generally higher for a lower number of sectors)
- the heterogeneity of the exposure size (the risk is higher when some sectors dominate)
- the underlying average credit risk of the sectors (large sectors with poorer average credit being key contributors)
- the credit dependency between sectors in the portfolio (sectors that tend to under-perform together)
Effective handling of sector concentration requires:
- proper identification (aggregation) of sector exposures on the basis of business activity
- measuring concentration using appropriate metrics
- a framework for monitoring and reporting sector concentrations against a limit framework
- applying mitigation actions and/or other management actions in accordance with that management framework
Issues and Challenges
- Sector concentration requires a valid aggregation of exposure to a sector. This task can have many gray areas: E.g., entities may be active in many sectors and a precise allocation is difficult
- Despite the long standing recognition of this risk, a consistent interpretation and measurement is still lacking, although there are a number of tools available