Sector Concentration

Although the importance of an appropriate methodology to quantify sector concentration risk is broadly recognized, the question how to measure sector concentration risk has not been answered yet. The occurrence of sector concentration directly results in violating the assumptions of the analytical Merton-type model, which constitutes the core under Pillar I of the Basel II framework for quantifying credit risk. In order to ensure analytical tractability of the model, the computation of regulatory capital is based on the so-called Asymptotic Single Risk Factor (ASRF) framework developed by the BCBS and, in particular, by [72]. However, the ASRF model assumes that all obligors depend on the same single systematic risk factor. Thus it measures only systematic risk and fails in detecting exposure concentrations as well as in recognizing diversification effects. The assumption of a single risk factor implies a uniform correlation among obligors and thereby can lead to an over- or underestimation of risk for portfolios with unequally distributed sector structure. Hence, to account for sector concentration risk a more general framework has to be considered.