The Network Effect in Credit Concentration Risk

Abstract

Measurement and management of credit concentration risk is critical for banks and relevant for micro-prudential requirements. While several methods exist for measuring credit concentration risk within institutions, the systemic effect of different institutions' exposures to the same counterparties has been less explored so far. In this paper, we propose a measure of the systemic credit concentration risk that arises because of common exposures between different institutions within a financial system. This approach is based on a network model that describes the effect of overlapping portfolios. This network metric is applied to synthetic and real world data to illustrate that the effect of common exposures is not fully reflected in single portfolio concentration measures. It also allows to quantify several aspects of the interplay between interconnectedness and credit risk. Using this network measure, we formulate an analytical approximation for the additional capital requirement corresponding to the systemic risk arising from credit concentration interconnectedness. Our methodology also avoids double counting between the granularity adjustment and the common exposure adjustment. Although approximated, this common exposure adjustment is able to capture, with only two parameters, an aspect of systemic risk that can extend single portfolios view to a system-wide one.