"Concentration risk" is a term that is often used in banking and finance circles. The term has to do with the relationship between the number of outstanding accounts serviced by the bank and the number and type of debtors that have received loans from the institution. Banks seek to use the assessment of this type of financial risk to maintain a reasonable balance between the deposits on hand and the total value of the loans currently underwritten.
Along with considering the overall face amount of the loans granted in relation to the number of accounts serviced by the bank, concentration risk also takes into consideration the nature of those loans. This includes identifying if the a significant percentage of the loans are similar in purpose, such as mortgages or car loans. Classifying loan types and determining how much of a percentage a particular class of loan represents in the overall calculation can aid in determining the level of concentration risk the bank is currently carrying in a given economic sector.
Ideally, a bank will want to keep concentration risk at a relatively low level. This is sometimes managed by making sure that riskier loan types only account for a certain percentage of the overall loans currently active. Doing so creates a situation in which a default of one of those riskier loans has less of an impact on the bank’s ability to continue providing services to its customers, since the losses with the one loan type are minimized by the continued good performance of the other loan types. In turn, this means that the bank remains financially stable, carries a reasonable amount of financial risk, and is not in any danger of having to close branches or reduce the range of services offered to its customers.
Along with understanding loan types and maintaining balance among those types, keeping the total monetary value of the active loans in line with the bank’s assets is also very important, if the institution is to remain financially viable. For this reason, the number and type of loans written may shift over time, based on the total value of customer deposits in various types of customer accounts. Should a bank lose clients and see those deposits shrink significantly, chances are the institution will partially curtail the approval of new loan applications until the bank is able to increase the total deposits once more. If the bank continues to lose customers, the degree of concentration risk will increase, possibly to the point of causing the bank to fail once it no longer has assets on hand to adequately support the total amount of loans written.