Beware Concentration Risk: Lessons in Avoiding Financial Risk Pitfalls

In just the last few years, there have been various events where the word “unprecedented” has been increasingly used in risk management circles. We have seen Brexit, COVID-19, the Russia-Ukraine war, surging inflation, rising interest rates and slowing global growth in the aftermath. Over the last few weeks, these challenges have reached a crescendo and we have now witnessed a spate of banking failures with their own “mini contagion” effects.

“Diversification is the only free lunch in finance” is a universal adage that helps guide optimal risk-adjusted return in good times. In volatile times, it can be an essential axiom in helping to avoid catastrophe. All these unprecedented events exposed financial institutions that were too concentrated in the wrong sector, either by intention or by neglect.

• The COVID-19 pandemic saw huge volatility in stock prices, with sector-specific effects, from high dispersion in leading industries like technology and pharmaceuticals to lagging industries like the hospitality and air travel sectors.
• Last year, Emerging Markets specialist fund manager Ashmore suffered a $14.3bn (18%) drop in assets under management from client outflows (Financial Times, 14 July 2022). This was due to a combination of investment losses driven by the macroeconomic headwinds and their heavy exposure to Russia and China, with the latter being negatively impacted by a sharp slowdown from post-pandemic shifts and major real estate defaults.
• Silicon Valley Bank’s lending book was almost exclusively comprised of exposure to the Venture Capital (VC)/technology start-up sector, which has faced a challenging year as the broader technology sector struggled. Meanwhile, the rising interest rates increased the costs of borrowing, increasing their refinancing risk and credit deterioration in the banking book. Moreover, with their deposit base being highly concentrated with venture capital/start-ups and their “hedge” book invested in long-dated treasuries and municipal/agency bonds, the culmination was a “perfect storm.”
• The issues at Credit Suisse have been well-documented, and while the Swiss lender is well-capitalized, it has had several concentrated losses despite navigating the global financial crisis better than most of its peers. The $5.5bn loss with Archegos, followed by the ill-fated involvement in Greensill Capital funds, which collapsed after, raised concerns over Credit Suisse’s large exposure to a single name in the steel and commodities industry. The emergency takeover of Credit Suisse by rival UBS for $3bn was an extraordinary, albeit somewhat unsurprising, the demise of a once-conservative Swiss lender, founded 167 years ago, whose market cap peaked at over $80bn. Controversially, the Swiss regulator wiped out their Additional Tier 1 bonds ($17bn) entirely, which will leave investors nursing further losses, with Asia-based private banks and certain hedge funds being particularly exposed.

There are several reasons why organizations struggle to measure and manage concentration risk. Having disparate systems to manage credit makes it difficult to get a single view of risk across an organization and makes it even more challenging to set and monitor risk appetite.

Poorly defined risk frameworks, controls and associated risk appetite can impact an organization in multiple ways—first with a potential for unwanted risk accumulation across the portfolio, but also with the potential for overly conservative lending decisions, higher credit losses, higher costs of capital and slower turnaround times in the market. There are a few niche institutions, such as SVB, where concentration in the VC/technology sector was intentional and part of their business model; however, in these cases, organizations need to monitor their concentration holistically so that they do not build up excess concentration in multiple areas across the portfolio.

These events and subsequent market impacts are cautionary tales (as outlined in our "Sobering Lessons from SVB: Manage Financial Risk Beyond Compliance" post) on the dangers of concentration risk and the impact of poor risk management in general. For institutions on both the Sell-Side and the Buy-Side, having a robust risk framework to accurately measure credit exposure on a consolidated and real-time basis is mission-critical, especially as markets dislocate and liquidity dries up. Senior management and Chief Risk Officers require a comprehensive view of risk across the entire institution and need to actively monitor their risk appetite across a variety of lenses with early warning signals, while traders and portfolio managers can more effectively manage day-to-day risk accurately on a real-time basis.

Vishal Sodha also contributed to this article.