What is concentration risk?

Concentration risk arises when a large part of a loan portfolio depends on the same source of repayment or the same economic driver. Concentrations can involve a single borrower and its affiliates, an industry, a property type, a geographic area, a collateral type or a loan product. Losses in concentrated portfolios tend to arrive together rather than one at a time.

Lenders manage concentration with limits set as a share of capital and monitored through regular reporting. US interagency guidance on commercial real estate concentrations highlights institutions where construction and land loans reach 100% of total risk-based capital, or where total CRE loans reach 300% of total risk-based capital and the CRE portfolio has grown 50% or more over 36 months. Legal lending limits cap exposure to a single borrower.

Concentrations are often understated because related borrowers are not aggregated, industry codes are inconsistent, or exposures such as participations and unfunded commitments are excluded. A portfolio can also be concentrated in less visible ways, such as many loans dependent on the same tenant or major employer. Stress testing helps quantify the impact of a downturn in a concentrated segment.