Question

If Super Corp. has a policy of limiting their loans to any single customer so that the maximum loss as a percent of capital will not exceed 18 percent for both secured and unsecured loans. The limit has been adopted under the assumption that if the unsecured loan is defaulted, there will be no recovery of interest or principal payments. For loans that are secured (collateralized), it is expected that 38 percent of interest and principal will be collected. What is the concentration limit as a % of capital for secured loans made by this bank? Briefly discuss the importance of the concentration ratio

Answer 1

The maximum loss as a percent of capital will not exceed 18 percent for both secured and unsecured loans.

Recovery rate in case of secured loan, R = 38%

Loss given default for secured loans, LGD = 1 - R = 1 - 38% = 62%

Maximum loss for secured loans = 18% = Concentration limit for secured loan x LGD for secured loan = Concentration limit for secure loan x 62%

Hence, the concentration limit as a % of capital for secured loans made by this bank = 18% / 62% = 29.03%

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Importance of concentration ratio / risk:

Concentration risk or ratio can be conceptually seen as how concentrated your loan book is on select few customers. It's opposite of diversified portfolio. A higher concentration risk means bank's portfolio is exposed to a select few customers. Concentration risk signifies lack of diversification. So, this signifies the risk of loss arising from large concentrated position in one / select few asset classes or customers or geography or borrowers. Higher the concentration risk, higher is the exposure of a bank to a select few debtors and hence, if such few debtors default, the bank runs a huge risk of loss, because of lack of diversification.