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Measuring Concentration Risk

Credit Concentration Risk

Concentration risk is the risk that a segment of the loan portfolio experiences a high level of loan losses, and that because the loan portfolio is highly concentrated in that segment, the losses may threaten the safety and soundness of the institution. Because of concentration risk, lenders monitor the concentration of the loan portfolio by loan type, collateral type, geographic market, borrower and tenant industry, and a variety of additional factors.

The ability to quickly and easily monitor concentration risk is a characteristic of commercial loan applications such as the Madison System. Concentration risk can be measured by the concentration of the current loan balance by segment, or of total exposure where exposure is the current loan balance plus the additional amount that may be drawn under existing lines. For example, if there is a high concentration in the Detroit market, if that market experienced significant economic weakness, the bank might have higher loan losses.

If the loan portfolio is further concentrated by other factors such as collateral type, potential losses could be even greater. If the portfolio has a high concentration of loans collateralized by office properties in the Detroit market, and there is a weakness in that segment, losses could have an adverse effect on bank capital. So it is valuable to be able to drill down into portfolio segments to gain a fuller understanding of concentration risk.

For commercial real estate loans it may also be important to measure exposure by the industry of major tenants. If there were a high concentration of tenants in the auto industry the portfolio might be riskier than if tenants were more diversified by industry.

Another key dimension of concentration risk is by borrower industry, especially for C&I loans.

Concentration Policy Limits

Because of the importance of concentration risk, most lenders have policy limits designed to prevent undue concentration of risk. So it is valuable to be able not only to easily view concentration risk, but also compare it to policy limits.

The Madison System includes automated features that allow users to measure concentration risk quickly and easily with the simple click of a mouse. The easier it is to see concentration risk, the easier it is to manage it, and present reports to the Loan Committee and Board of Directors.