CONCENTRATION RISK PROFILE OF INDIAN COMMERCIAL

BANKS
Introduction:
Risk selection is more important than risk management in determining a banks
credit performance
Credit risk strategy results from a banks tolerance for risk as evidenced by how it
selects, manages, and diversifies risk. Banks are moving away from a buy-and-hold
strategy with respect to their loans. They are now syndicating risk, distributing the
risk to enhance the value of their portfolio. When originating a loan, banks need
evaluate how much incremental risk they are adding, how much they need to be
compensated for taking that risk. Many banks look at each credit inside than across
the enterprise to understand the incremental risk that the new loan is adding the
loans. Portfolio theory applies equally to collections of credit risks as to equity and
other investments. The purpose of having a portfolio of assets, instead of a single
asset, is to reduce risk through diversification without sacrificing the rate of
return21 . An efficient portfolio achieves a specified rate of return with the minimum
possible risk for specified level of risk of for the maximum possible rate of return.
The principle, which underlines portfolio management, is diversification of risk22 .
The objective of this chapter is to present a general framework for quantification of
concentration risk followed by concentration risk profiling of public sector banks vis-vis private sector banks; and to explore the relationship between concentration
risk profile and NPAs level.

Concentration risk: A new methodology adopted to evaluate the volatility in

portfolio performance predicated on the risk profile of the institution. The banking
industry has relied heavily on prior experience as a predictor of future credit
performance. Concentration risk23 is the aggregation of transaction and intrinsic
risk within the portfolio and may result from loans to one borrower or one industry,
geographic area, or line of business. Senior management must define acceptable
portfolio concentrations for each of these aggregations. The most conservative
banks manage borrower exposure through restrictive house limits and maximum
exposure to industries and lines of business. Many banks also have wisely sought to
mitigate risk through geographic diversification. Aggressive banks have traditionally
accepted hogs shares of individual borrower, lines of business, and industry
exposures. Managing concentration limits will become a high priority for these
lenders in the future because of the lingering pain from lessons learned in
commercial real estate, energy etc.
Concentration risk strategy: The bank does have an opportunity to reduce their
concentration in one line of business or industry. Outstanding would have to be
replaced with more lending focused on lower risk lines of business and borrowers.

Banks must constantly monitor the risk profile to determine it future lending
practices are consistent with the desired risk profile.
Selecting a Risk Strategy: Using the risk profile as a frame of reference,
management should select a risk strategy that will be consistent with long-term
objectives for portfolio quality and performance. The three variable risk strategies in
order of riskiness are: Conservative, Managed and Aggressive. The selection of the
appropriate strategy depends on a bank s priorities and risk appetite. Most often,
the choice is not made as part of a formal process but evolves as the bank seeks its
desired risk posture through its lending practices. Consequently, few banks have a
clear picture of the risk profile that will emerge. A selection of risk strategy with
specific implementation plans provides a much better idea of the future risk profile.
The following guidance should help in understanding, which strategy best serves
managements intent;

(i)
(ii)

(iii)

Conservative: Accepts relatively low levels of transaction, intrinsic and

concentration risk. The strategy normally supports a values-driven culture.
Managed: Accepts relatively low levels of risk in two categories but high
levels in one category. For example: a bank that takes conservative levels
of concentration and transaction risk but is more aggressive with intrinsic
risk. The strategy normally promotes the immediate performance culture.
Aggressive: Accepts relatively low levels of risk in one category, more
aggressive risk in two categories. An example would be a bank that
closely manages transaction risk but accepts higher levels of intrinsic and
concentration risk. This strategy is normally employed in a production
driven culture.

Obviously, credit volatility rises as the levels and categories of risk are
increased. The aggressive strategy requires more careful management because
it operates closer to the danger zone. If risk in all three categories reaches high
levels, the bank s credit volatility becomes so great in a downturn that capital
adequacy and survival could become real issues.

Impact of concentration risk on NPAs level: The concentration risk is an

important component of the credit risk and is prompted by the concentration of
the credit portfolio in one or two occupations or industries. It is desirable to
achieve a diversified credit portfolio in order to minimize the occupation-wise
concentration risk as well as industry-wise concentration risk. It has been the
experience of the commercial banks that higher NPAs level is generally
associated with high degree of concentration risk-both occupation-wise and

industry-wise. In order to analyse the observed relationship between NPAs level

and concentration risk, the relevant data is presented in this section.
The highest level of NPAs, i.e., 24.8 percent in the year 1994 corresponds to the
maximum index value in the same year. Similarly, the minimum level of NPAs,
i.e., 9.36 percent in the year 2003 corresponds to the lowest index value in the
same year. Overall, the decrease in occupation-wise concentration risk is
matched by the corresponding decrease in NPAs level.
An attempt was made to quantify the relationship between concentration-index
and NPAs level by way of coefficient of correlation and the results found to be
satisfactory in reinforcing our earlier observations. Table 4.1 lists the results

As observed earlier, there exists a strong positive relationship between

occupationwise concentration-index and NPAs level in case of both the public
sector banks and private sector banks with the coefficient of correlation value
being 0.80 and 0.67 respectively. This is confirmed by the higher values of
coefficient of determination of 0.64 and 0.45 for public sector banks and private
sector banks respectively. Similarly, there exists a strong positive relationship
between industry-wise concentration-index and NPAs level in case of public
sector banks as confirmed by a very high value of r 2 = 0.78. But this is not
clearly pronounced in the case of private sector banks as indicated by lower
value of r 2 = 0.27.
Conclusion:

Concentration risk is a very significant component of overall credit risk profile of

a banking institution. A prudent credit risk management is based on the principle
of diversified portfolio to avoid concentrations in any one or couple of
occupations or industry. Trends in concentration risk profile of public sector
banks during the post-liberalization period clearly indicate a paradigm shift in
the portfolio approach to credit risk management. The occupation-wise and
industry-wise concentrations reduced significantly during the study period. On
the contrary, the trends in concentration risk profile of private sector banks
signify an opposite direction. The occupation-wise concentration risk increased
substantially from 37 percent in 1999 to 59 percent in 2003. Both the
approaches suggested for quantification of concentration risk yielded
satisfactory results. Under the profile-score method, with a score of less than 10
for public sector banks, and more than 10 for private sector banks, it is
concluded that public sector bank s risk profile is low while that of private sector
bank s risk is moderate. Similarly, under the concentration-index method it was
found that there exists strong relationship between occupation-wise
concentration risk profile and NPAs level with higher values of coefficient of
determination of 0.64 and 0.45 for public sector banks and private sector banks
respectively. Similarly, strong positive relationship between industry-wise
concentration risk and NPAs level in case of public sector banks, as confirmed by
high value of r 2 =0.78. But same is not pronounced in case of private sector
banks. Based on these results it can be concluded that
1. The declining trends in Non-Performing Assets (NPAs) in public
sector banks during the post-liberalization period is an outcome mainly
caused by the improved credit portfolio diversification.
2. The concentration risk profile of credit portfolio of private sector
banks is higher than that of public sector banks impacting adversely
the NPAs level of private sector banks vis--vis public sector banks.