How to measure single-name credit risk concentrations

Abstract

Credit risk concentration is one of the leading topics in modern finance, as the bank regulation has made increasing use of external and internal credit ratings. Concentration risk in credit portfolios comes into being through an uneven distribution of bank loans to individual borrowers (single-name concentration) or in a hierarchical dimension such as in industry and services sectors and geographical regions (sectorial concentration). To measure single-name concentration risk the literature proposes specific concentration indexes such as the Herfindahl–Hirschman index, the Gini index or more general approaches to calculate the appropriate economic capital needed to cover the risk arising from the potential default of large borrowers. However, in our opinion, the Gini index and the Herfindahl–Hirschman index can be improved taking into account methodological and theoretical issues which are explained in this paper. We propose a new index to measure single-name credit concentration risk and we prove the properties of our contribution. Furthermore, considering the guidelines of Basel II, we describe how our index works on real financial data. Finally, we compare our index with the common procedures proposed in the literature on the basis of simulated and real data.