Credit Concentration and Cyclical Economic Capital of Loan Portfolios

Abstract

This paper proposes a framework to analyze concentration risk of loan portfolios by quantifying the amount of economic capital(EC) throughout an economic cycle. The empirical investigation using the Bank of Thailand’s default data demonstrates that credit concentration risk is a major cause of an extreme credit portfolio loss event faced by commercial banks that conduct relationship lending business. It shows that five major industries of aggregate national loan portfolios are highly exposed to the same common risk factors, in addition to the macroeconomic risk factors that drive the default rate. The findings suggest that an estimate of the time varying risk level in the Thai loan market is important to:(i)policy makers as they design the appropriate level of regulatory capital,(ii)credit portfolio managers because they likely identify medium and long-­‐term business plans, and(iii) risk managers because they need to predict short-­‐ and long-­‐term default risk in their credit portfolios in order to set out an effective risk mitigation plan.