Keeping a handle on concentration risk

Don’t put all your eggs in one basket. Sometimes we ignored these bits of wisdom from Grandma but heeding her advice could have avoided millions of dollars in losses since the Wall Street debacle of 2008 – 2009. Yes, it is far more complex than what that sweet grey-haired lady’s sage wisdom imparted.  It’s no longer about just one ‘basket’ and those ‘eggs’ represent billions of dollars in loans, investments and deposits circulating through the U.S. financial system.  We’ve come to recognize that Concentration Risk is our ‘basket’ and seen as the culprit in numerous financial industry fiascos in the last thirty years.  However, is the basket to blame when all of the eggs are broken, or is it those hands carrying the basket?  Effective management of this risk is the only way to protect our financial institutions and industry from Concentration Risk scenarios that occurred during the 1980’s with the Savings and Loan crisis as well as the erosion of value experienced in the mortgage-backed securities market due to poorly underwritten underlying mortgages in the first decade of this century.  Only through recognizing, measuring and managing Concentration Risk can we avoid history repeating these costly disasters.

Any significant grouping of like or similar asset and/or liabilities can result in a “concentration”.  Concentrations increase in risk proportional to their size.  For example, if I have evenly distributed groups of assets, then it is more likely that my risk is also evenly distributed.  The greater I increase any one of those asset groups, the greater risk I must assume for that group. Where are the concentrations that should concern us?  Everywhere:

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