Concentration risk is most commonly associated with lending, particularly with commercial real estate lending.
This remains true today, with the Government Accountability Office’s predictive models of CRE loan performance indicating that concentration risk in CRE lending has risen based on an increase of both bank CRE lending and CRE prices the past few years, according to a 2018 report. Though levels remain lower than they were during the financial crisis and regulators are giving more regulatory scrutiny to institutions with high concentrations in CRE lending, it remains a potential risk. For example, the NCUA recently noted that lending concentration is a top supervisory priority.
Yet concentration is about more than loan portfolios. By definition, concentration risk is managing concentrations, or pools of exposures, that could collectively have a negative impact. This is true even when each element in the pool is strong.
“When exposures in a pool are sensitive to the same economic, financial, or business development, that sensitivity, if triggered, may cause the sum of the transactions to perform as if it were a single, large exposure,” the OCC wrote in its 2011 Concentrations of Credit.
Looking ahead, the New York Federal Reserve is warning of a different kind of concentration risk: industry concentration.
Since the financial crisis, banks have increased their capital ratios and liquidity and improved their risk management due to increased regulatory scrutiny. The result is safer banks.
Yet while these banks are individually safer, they are also increasingly similar. Early research from the NY Fed indicates that big bank balance sheets for both assets and liabilities are starting to converge. They have similar loan-to-asset ratios and composition of loan balances with a similar shift to wholesale funding.
“If firms expand, diversify, and become more similar, each might become safer individually. The industry, however, might not be any safer or more resilient,” said Kevin J. Stiroh, NY Fed executive vice president in a speech late last year. “If all firms are effectively the same, they could become ‘systemic as a herd’ and susceptible to the same shocks in a way that leaves the aggregate provision of financial services more volatile.”
It’s ironic that diversifying to make an institution stronger can actually make the industry weaker by creating homogeneity.
Concentration risk is also an issue with vendors.
- Over-reliance on a single vendor. This is a classic case of putting all your eggs in one basket. If an institution relies heavily on a single provider for many products and services—especially critical ones—that institution might be unable to conduct business if something catastrophic happens to that vendor.
- Geographic concentration. If both an institution and its third-party vendors and subcontractors are in the same region, it’s possible the same event could impact everyone’s operations since they all rely on the same power and telecommunications infrastructure.
These risks can be managed by diversifying vendors or ensuring there is a solid back-up plan in the event of a vendor failure. Due diligence is an absolute must.
Concentration Risk Going Forward
As we continue into 2019, make sure your institution is looking broadly at concentration risk. While it’s essential to evaluate your own loan portfolio, third-party vendor contracts, and other internal issues, take the time to look at your operating environment as a whole to understand where concentrations exist and what strategies can be used to mitigate them.
To learn more about the top risks you need to think about in 2019, join us for our webinar, Don’t Worry. Be Ready: Understanding Top Risk Trends of 2019.