Concentration risk
Encyclopedia
Concentration risk is a banking
term denoting the overall spread of a bank's outstanding accounts over the number or variety of debtor
s to whom the bank has lent money. This risk is calculated using a "concentration ratio" which explains what percentage of the outstanding accounts each bank loan represents. For example, if a bank has 5 outstanding loans of equal value each loan would have a concentration ratio of .2; if it had 3, it would be .333.
Various other factors enter into this equation in real world applications, where loans are not evenly distributed or are heavily concentrated in certain economic sectors. A bank with 10 loans, valued at 10 dollars a piece would have a concentration ratio of .10; but if 9 of the loans were for 1 dollar, and the last was for 50, the concentration risk would be considerably higher. Also, loans weighted towards a specific economic sector would create a higher ratio than a set of evenly distributed loans because the evenly spread loans would serve to offset the risk of economic downturn and default
in any one specific industry damaging the bank's outstanding accounts.
Risk of default
is an important factor in concentration risk. The basic issue raised by the concept of default risk is: does the risk of default on a bank's outstanding loans match the overall risk posed by the entire economy or are the bank's loans concentrated in areas of higher or lower than average risk based on their volume, type, amount, and industry.
Bank
A bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...
term denoting the overall spread of a bank's outstanding accounts over the number or variety of debtor
Debtor
A debtor is an entity that owes a debt to someone else. The entity may be an individual, a firm, a government, a company or other legal person. The counterparty is called a creditor...
s to whom the bank has lent money. This risk is calculated using a "concentration ratio" which explains what percentage of the outstanding accounts each bank loan represents. For example, if a bank has 5 outstanding loans of equal value each loan would have a concentration ratio of .2; if it had 3, it would be .333.
Various other factors enter into this equation in real world applications, where loans are not evenly distributed or are heavily concentrated in certain economic sectors. A bank with 10 loans, valued at 10 dollars a piece would have a concentration ratio of .10; but if 9 of the loans were for 1 dollar, and the last was for 50, the concentration risk would be considerably higher. Also, loans weighted towards a specific economic sector would create a higher ratio than a set of evenly distributed loans because the evenly spread loans would serve to offset the risk of economic downturn and default
Default (finance)
In finance, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either...
in any one specific industry damaging the bank's outstanding accounts.
Risk of default
Default (finance)
In finance, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either...
is an important factor in concentration risk. The basic issue raised by the concept of default risk is: does the risk of default on a bank's outstanding loans match the overall risk posed by the entire economy or are the bank's loans concentrated in areas of higher or lower than average risk based on their volume, type, amount, and industry.