Concentration Risk Profile of Indian Commercial Banks

CONCENTRATION RISK PROFILE OF INDIAN COMMERCIAL BANKS Introduction: “Risk selection is more important than risk management in determining a bank’s credit performance” Credit risk strategy results from a bank’s tolerance for risk as evidenced by how it selects, manages, and diversifies risk. Banks are moving away from a buy-and-hold strategy with respect to their loans. They are now syndicating risk, distributing the risk to enhance the value of their portfolio. When originating a loan, banks need evaluate how much incremental risk they are adding, how much they need to be compensated for taking that risk. Many banks look at each credit inside than across the enterprise to understand the incremental risk that the new loan is adding the loans. Portfolio theory applies equally to collections of credit risks as to equity and other investments. The purpose of having a portfolio of assets, instead of a single asset, is to reduce risk through diversification without sacrificing the rate of return21 . An efficient portfolio achieves a specified rate of return with the minimum possible risk for specified level of risk of for the maximum possible rate of return. The principle, which underlines portfolio management, is ‘ diversification of risk22’ . The objective of this chapter is to present a general framework for quantification of concentration risk followed by concentration risk profiling of public sector banks visà-vis private sector banks; and to explore the relationship between concentration risk profile and NPAs level.

Concentration risk: A new methodology adopted to evaluate the volatility in portfolio performance predicated on the risk profile of the institution. The banking industry has relied heavily on prior experience as a predictor of future credit performance. Concentration risk23 is the aggregation of transaction and intrinsic risk within the portfolio and may result from loans to one borrower or one industry, geographic area, or line of business. Senior management must define acceptable portfolio concentrations for each of these aggregations. The most conservative banks manage borrower exposure through restrictive house limits and maximum exposure to industries and lines of business. Many banks also have wisely sought to mitigate risk through geographic diversification. Aggressive banks have traditionally accepted hogs ‘shares’ of individual borrower, lines of business, and industry exposures. Managing concentration limits will become a high priority for these lenders in the future because of the lingering pain from lessons learned in commercial real estate, energy etc. Concentration risk strategy: The bank does have an opportunity to reduce their concentration in one line of business or industry. Outstanding would have to be replaced with more lending focused on lower risk lines of business and borrowers.

Banks must constantly monitor the risk profile to determine it future lending practices are consistent with the desired risk profile. Selecting a Risk Strategy: Using the risk profile as a frame of reference, management should select a risk strategy that will be consistent with long-term objectives for portfolio quality and performance. The three variable risk strategies in order of riskiness are: Conservative, Managed and Aggressive. The selection of the appropriate strategy depends on a bank’ s priorities and risk appetite. Most often, the choice is not made as part of a formal process but evolves as the bank seeks its desired risk posture through its lending practices. Consequently, few banks have a clear picture of the risk profile that will emerge. A selection of risk strategy with specific implementation plans provides a much better idea of the future risk profile. The following guidance should help in understanding, which strategy best serves managements intent;

(i) (ii)

(iii)

Conservative: Accepts relatively low levels of transaction, intrinsic and concentration risk. The strategy normally supports a values-driven culture. Managed: Accepts relatively low levels of risk in two categories but high levels in one category. For example: a bank that takes conservative levels of concentration and transaction risk but is more aggressive with intrinsic risk. The strategy normally promotes the immediate performance culture. Aggressive: Accepts relatively low levels of risk in one category, more aggressive risk in two categories. An example would be a bank that closely manages transaction risk but accepts higher levels of intrinsic and concentration risk. This strategy is normally employed in a production driven culture.

Obviously, credit volatility rises as the levels and categories of risk are increased. The aggressive strategy requires more careful management because it operates closer to the danger zone. If risk in all three categories reaches high levels, the bank’ s credit volatility becomes so great in a downturn that capital adequacy and survival could become real issues.

Impact of concentration risk on NPAs level: The concentration risk is an important component of the credit risk and is prompted by the concentration of the credit portfolio in one or two occupations or industries. It is desirable to achieve a diversified credit portfolio in order to minimize the occupation-wise concentration risk as well as industry-wise concentration risk. It has been the experience of the commercial banks that higher NPAs level is generally associated with high degree of concentration risk-both occupation-wise and

industry-wise. In order to analyse the observed relationship between NPAs level and concentration risk, the relevant data is presented in this section. The highest level of NPAs, i.e., 24.8 percent in the year 1994 corresponds to the maximum index value in the same year. Similarly, the minimum level of NPAs, i.e., 9.36 percent in the year 2003 corresponds to the lowest index value in the same year. Overall, the decrease in occupation-wise concentration risk is matched by the corresponding decrease in NPAs level. An attempt was made to quantify the relationship between concentration-index and NPAs level by way of coefficient of correlation and the results found to be satisfactory in reinforcing our earlier observations. Table 4.1 lists the results

As observed earlier, there exists a strong positive relationship between occupationwise concentration-index and NPAs level in case of both the public sector banks and private sector banks with the coefficient of correlation value being 0.80 and 0.67 respectively. This is confirmed by the higher values of coefficient of determination of 0.64 and 0.45 for public sector banks and private sector banks respectively. Similarly, there exists a strong positive relationship between industry-wise concentration-index and NPAs level in case of public sector banks as confirmed by a very high value of r 2 = 0.78. But this is not clearly pronounced in the case of private sector banks as indicated by lower value of r 2 = 0.27. Conclusion:

Concentration risk is a very significant component of overall credit risk profile of a banking institution. A prudent credit risk management is based on the principle of diversified portfolio to avoid concentrations in any one or couple of occupations or industry. Trends in concentration risk profile of public sector banks during the post-liberalization period clearly indicate a paradigm shift in the portfolio approach to credit risk management. The occupation-wise and industry-wise concentrations reduced significantly during the study period. On the contrary, the trends in concentration risk profile of private sector banks signify an opposite direction. The occupation-wise concentration risk increased substantially from 37 percent in 1999 to 59 percent in 2003. Both the approaches suggested for quantification of concentration risk yielded satisfactory results. Under the profile-score method, with a score of less than 10 for public sector banks, and more than 10 for private sector banks, it is concluded that public sector bank’ s risk profile is low while that of private sector bank’ s risk is moderate. Similarly, under the concentration-index method it was found that there exists strong relationship between occupation-wise concentration risk profile and NPAs level with higher values of coefficient of determination of 0.64 and 0.45 for public sector banks and private sector banks respectively. Similarly, strong positive relationship between industry-wise concentration risk and NPAs level in case of public sector banks, as confirmed by high value of r 2 =0.78. But same is not pronounced in case of private sector banks. Based on these results it can be concluded that 1. “The declining trends in Non-Performing Assets (NPAs) in public sector banks during the post-liberalization period is an outcome mainly caused by the improved credit portfolio diversification”. 2. “The concentration risk profile of credit portfolio of private sector banks is higher than that of public sector banks impacting adversely the NPAs level of private sector banks vis-à-vis public sector banks”.