Active management of concentration is a key objective of any credit portfolio management effort. This article outlines a sound but practical portfolio limit framework that allows an institution to manage concentration risk yet position itself to respond quickly to market changes.

It's common to hear praise for concentration limits as an important portfolio management tool. It's equally common, however, for enforcement of portfolio limits to fall prey to political and budgetary pressures. The challenge of today's portfolio manager is to create a portfolio limit system that is at once both effective in protecting the institution from single credit events and practical in its enforcement.

Setting limits isn't a one-size-fits-all process. Individual considerations include:

* The size and nature of the institution.

* Strategy.

* Credit appetite.

* Competitive advantages.

* Systems.

* The existing level of portfolio diversification.

Many banks have expertise in certain sectors or regions that may justify extra concentration of risk. It is worth noting that, diversification for the sake of diversification, particularly in areas where an institution has little expertise, may actually add to risk rather than reduce it.

Healthy, effective limit systems are designed to flag pockets of vulnerability. They create a framework for discussions among Risk Management, the origination groups, and Portfolio Management. In doing so, they are a key part of a culture that directs the day-to-day activities of an institution around return and risk optimization.

Many types of limits are available for a given portfolio of credit exposures. Limits can be set by product, asset class, business lines, ratings, geography, industry, lending office, origination group, obligor, or duration, just to name a few. The appropriate combination of limits depends on the number of business lines, the size and geographic spread, the sophistication of management and staff, the robustness of the systems, and the complexity of product offerings and activities.

There is no one ideal limit system, but since the objective is to manage credit exposure in a way that affords protection against a single credit event, the system should at least be able to report and monitor the credit portfolio by obligor, industry, and region. This is in line with the minimum information that rating agencies require to evaluate such portfolio structures as CLOs (collateralized loan obligations) and CBOs (collateralized bond obligations): issuer concentrations, industry concentrations, and regional or country concentrations. Follow-up servicing reports to investors also use such information to report on the performance of the portfolios. Limits and triggers are often placed on the asset pool in terms of maximum limits for a single obligor and maximum concentration by sector or region. Hedge funds and prime funds also manage themselves within similar limits.

Some corporate finance professionals would argue that an institution receives no benefit in its share price from diversifying activities because investors are able to diversify on their own. However, many others believe that increasing the number of obligors in any pool diversifies credit risk and reduces the volatility associated with an earnings stream, which, in turn, leads to a higher valuation multiple.

Standard & Poor's observes that although diversification by sector is beneficial, there is a diminishing marginal benefit to diversifying a portfolio by industry. Although S&P tracks exposures by 39 industry categories, it assumes that a pool of assets distributed over as few as 13 industries (that is, no sector accounting for more than 8% of assets) is fairly diversified. In rating a CLO, ratings agencies will notch a rating down for each obligor in the sector to the degree by which the sector exceeds the 8% guideline.

It is important to recognize that an institution limited by geography, strategy, or expertise does not always have natural opportunities for diversification. This again highlights the importance of aligning the portfolio management mandate and the limit system with the strategy of the bank.

Loan Equivalent Exposures

When an institution sets portfolio limits, it is ultimately trying to manage notional exposure. Nevertheless, the vagaries and customization that are available around the credit product make it difficult to compare notional exposure across obligors, sectors, and regions. A $100 million exposure to a AAA-rated entity is not equivalent to a $100 million exposure to a BB-rated entity; similarly, an unsecured facility to a single-B obligor is not viewed in the same way as a secured obligation in the same amount to another single-B entity. The question is further complicated by the increasing number of derivatives products that are available. A $10 million notional interest rate swap with a counterparty does not represent the same risk as a $10 million funded loan to the same counterparty.