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

References