Having been on the road and transitioned through 4 continents since  early January, I have spent many a recent hour in an airport lounge counting airplanes and people watching.  With my wife and children left behind in good old "blighty" I've had plenty of time to ponder the current turmoil in the financial services industry.

As I laid awake in the numerous hotel rooms I visited, struggling with many a sleepless night, it got me thinking.

Thinking about what was keeping others awake.

If we look at what lays behind most of the major banking disasters in history we can see Credit concentration raising its head and we just don't seem to be learning our lessons.

What's the chance of everything going wrong at the same time in your credit portfolio?

That's really the question that keeps bank­ers- their shareholders, their customers and lets not forget their regulators-awake at night.

Ok it can be argued that until recently, borrower correlation and concentration risks have been difficult for the banking industry to measure in an objective way. Even Basel II reforms largely dodged the measurement issue by shunting correlation risk into Pillar 2 (super­visory review) rather than Pillar 1 (minimum capital requirements).

As a result, bank efforts to manage concentration risk are often based around broad-brush notional lim­its on particular names and sectors that fail to:

• Make a quantitative link to the correlations driving risk in each segment and may therefore fail to prevent concentrations from accumulating.

 

• Capture the multidimensional, enterprise-wide threat from concentration risk.

 

• Put dollar costs against concentration risks to promote rational decision making in this tricky area of risk management.

Risk management aside, broad-brush limits are bad for business because they restrict bank expansion in growth sectors where there may be no real economic reason for restraint.

This is particularly unfortunate for midsized re­gional and smaller banks that lack the enormous risk diversification benefits of the large banks and need to leverage their specialist skills in particular lending niches, including commercial real estate lending, if they are to compete.

So how can banks better understand the power of name and sectoral credit concentration risks, and learn to manage them in a transparent, rational way that maximizes risk-adjusted returns (and that reas­sures regulators)?

Banks with heavy correlation risks can make money and steer clear of trouble, so long as they hold enough risk capital to protect the bank against the higher level of unexpected losses and charge their customers ac­cordingly (or exit markets where market pricing makes charging for concentration risks impossible).

Where these skills are lacking, banks with strongly correlated portfolios suffer the double blow of heavy losses followed by the need to adjust ongoing business strategy (at a time when their credibility is low with investors and those charged with oversight). That is, if the bank manages to remain solvent!

Having spent 17 hours asleep over the weekend, I can safely say my jetlag is behind me, at least until my next trip, but is yours!