Concentration of Credit Risk Disclosure Requirements

Companies are required to disclose concentration of credit risk in their financial statements. This disclosure is typically found in the footnotes of the financial statements.

The Securities and Exchange Commission (SEC) requires companies to disclose concentrations of credit risk in their debt and equity investments. This includes concentrations with a single issuer, industry, or geographic location.

The SEC also requires companies to disclose the total amount of credit risk exposure, as well as the amount of credit risk exposure to each individual counterparty. This information is typically presented in a table or list format.

Companies must provide this disclosure to help investors and other stakeholders understand the potential risks associated with the company's credit exposure.

Concentration of credit risk is a type of risk that occurs when a significant portion of a credit union's assets or liabilities are concentrated in a single area, making the credit union vulnerable to a severe impact if something goes wrong in that area.

This type of risk can be found in various forms across credit union operations, including asset classes, concentrations within a class of assets, liabilities, third-party providers, and services provided to other parties.

Examples of concentration risk include residential real estate loans, member business loans, automobile loans, loan participations or investments, rate sensitive share deposits or callable borrowings, CUSOs, indirect loan partners or mortgage brokerage firms, and loan underwriting and/or servicing, insurance services, and investment consultation.

A clear example of this concept would be a credit union that holds a portfolio of real estate loans and also a portfolio of mortgage backed securities, which share common event risks that must be quantified and mitigated by management.

To illustrate the concept, consider a credit union with a portfolio of real estate loans that represents 50% of total loans. In this case, the sophistication and depth of risk management systems and analysis conducted on this portfolio would be more advanced compared to a portfolio that represents 20% of total loans.

Credit unions must be aware of other asset categories that may seem unrelated, such as loan participations or investments, which can also pose concentration risk.

Here are some examples of concentrations that can make a credit union vulnerable to a severe impact:

Identifying and measuring concentration risk is crucial for credit unions to manage their financial exposure. Management needs to perform a risk assessment that demonstrates their understanding of the risk of each product or service, quantifies the potential loss exposure, and documents a rational business decision on the acceptable concentration level.

Concentration risk is present in many forms across credit union operations, including asset classes, liabilities, third-party providers, and services provided to other parties. Examples of asset classes include residential real estate loans, member business loans, automobile loans, loan participations, or investments.

To identify and measure concentration risk, credit unions must start with the systems used to store and analyze their data. For more complex products, establishing comprehensive data warehousing will allow management to track changes in the quality of their various lines of business over time.

A clear example of this concept would be a credit union that holds a portfolio of real estate loans and also a portfolio of mortgage-backed securities. There are common event risks in these types of assets that must be quantified and mitigated by management.

The larger the concentration level, the more robust and advanced the analysis and risk management techniques should be. For instance, the sophistication and depth of risk management systems and analysis conducted on a real estate portfolio that represents 20 percent of total loans could be acceptably less than a real estate portfolio that represents 50 percent of total loans.

The following table illustrates the importance of monitoring concentration risk:

Note that the level of analysis and risk management techniques required will vary depending on the specific credit union and its operations.

Reporting and disclosure are crucial aspects of managing concentration of credit risk. Management reporting must be periodic and timely, in a format that clearly indicates changes in concentration risk.

The frequency of reporting should be commensurate with the type and size of the concentration; for example, larger portfolios should have at least quarterly reporting. In one instance, a company reported that its largest customer accounted for approximately 15% of net sales to third parties, and the second largest and third largest customers accounted for 13% and 8% of net sales to third parties, respectively.

Credit risk disclosure is also essential, as seen in the example of a company that disclosed its concentration of credit risk in its financial statements. The company periodically assesses country and customer credit risk, assigns individual credit limits, and takes actions to mitigate credit risk where appropriate.

A risk rating system is essential for managing concentration risk in a loan portfolio, and it should be objective, sensitive to changes in borrower and/or loan characteristics, and validated via an independent review function.

Developing such a system requires a thorough and ongoing due diligence process, especially when relying on an external institution's rating system. This due diligence should be documented and consistent with safe and sound business practices.

Management should not rely solely on the originating institution's system without completing this due diligence.

Reporting is crucial for managing concentration risk, and it must be done in a timely and periodic manner. The frequency of reporting should be commensurate with the size and complexity of the concentration.

Larger portfolios should have at least quarterly reporting, while smaller ones can get away with annual reporting. This ensures that management stays on top of concentration risk and can make informed decisions.

Management reporting should clearly indicate changes in concentration risk and be commensurate with the size, complexity, and risk exposure of the credit union. This means that the report should be tailored to the specific needs of the organization.

For example, a key factor in determining concentration risk in a loan portfolio is to measure credit score migration by obtaining updated credit scores on a periodic basis and analyzing those borrowers who have a declining credit score.

Managing credit concentration risk is crucial for financial institutions to avoid significant losses. Concentration risk has a substantial influence on credit, strategic, reputation, interest rate, and liquidity risks, all of which impact net worth.

To manage concentration risk, credit unions must implement sound risk management practices, which include maintaining concentration risk within parameters set by the board of directors. Senior management is responsible for ensuring that risk management practices are commensurate with the risk assumed relative to net worth.

The board of directors must establish a policy that addresses concentration risk, including limits commensurate with net worth levels. These limits should be specific to each portfolio and include parameters such as loan types, share types, and third-party relationship exposure. The risk limits should correlate to the overall growth objectives, financial targets, and net worth plan.

Concentration Risk Limits

Regular formal reporting to the board and senior management on compliance with concentration and risk limits is essential. Management should also implement appropriate internal controls, including segregation of duties, to ensure accurate reporting on concentration risk.

The board of directors is ultimately responsible for setting the level of concentration risk assumed by the credit union. This responsibility is a critical one, as concentration risk has a substantial influence on multiple types of risk, including credit, strategic, reputation, interest rate, and liquidity risks.

Senior management is responsible for maintaining concentration risk within the parameters set by the board of directors. This involves monitoring and controlling the risk to ensure it doesn't exceed acceptable levels.

The board of directors must establish a policy that addresses its philosophy on concentration risk, limits commensurate with net worth levels, and the rationale for those limits. This policy should be developed with a global perspective, considering outside forces that could affect the ability to manage concentration risk.

Regular formal reporting to the board and senior management on compliance with concentration and risk limits is essential. This reporting should include accurate information on concentration risk, which can be ensured through the implementation of internal controls like segregation of duties.

Concentration risk limits should be specific to each portfolio and include limits on loan types, share types, and third-party relationship exposure. These limits should be closely linked to related policies, such as real estate loan, member business loan, and investment policies.

Scenario and sensitivity analysis is a crucial step in managing credit concentration risk. It allows credit unions to predict the potential impact of changing economic conditions on their assets, earnings, and net worth.

Scenario analysis uses a model to predict a possible future outcome given an event or a series of events. This can help credit unions anticipate and prepare for potential risks.

Credit unions should consider the susceptibility of portfolio segments with common risk characteristics to changing market conditions. Examples of common risk characteristics include loan type, investment type, collateral type, geographic area, and individual or associational groups of borrowers.

For instance, a credit union with a concentration in HELOC mortgages should analyze the risk to earnings if unemployment in the area doubles while house market values decline by 25 percent, combined with the effect of interest rate resets and associated payment shock.

Sensitivity analysis tests a model's parameters without relating those changes to an underlying event or real-world outcome. This can help credit unions determine which assumptions have the most impact on their model's results.

The analyses should be multi-faceted to explore the effect of single and multiple simultaneous negative events on the portfolio. This can help credit unions understand the potential consequences of various scenarios.

The sophistication of scenario and sensitivity analyses should be consistent with the size, complexity, and risk characteristics of the portfolio as a whole.

Compliance and oversight are crucial in managing concentration of credit risk. Senior management must implement procedures and controls to adhere to and monitor compliance with established policies and strategies.

Senior management needs to periodically review information that identifies and measures the level and nature of concentration risk. They must also implement corrective action if the risk from any one area exceeds the board-approved tolerance level.

Credit unions with large and complex loan or investment programs should establish a specific risk management committee. This committee should be composed of a small number of senior executives and one or more board members.

The agenda of this committee should be limited to risk management issues, specifically concentration risk, credit risk, interest rate risk, liquidity risk, and financial performance. Management should demonstrate compliance with every board-established policy limit dealing with concentration risk.

Examiners should ask credit unions specific questions to assess concentration risk, including whether they have policies directly related to identifying, measuring, monitoring, and controlling concentration risk.

Examiners should ensure credit unions consider the potential impact of various types of concentrations and their interrelationship, particularly between asset classes or common products and service characteristics, which may present higher risk when aggregated.

Credit unions should have predetermined actions to take when risk limits are reached, and these actions should be based on advanced analysis supporting the rationale for the change in policy.

A material red flag is a credit union that simply raises the established limit when it is reached without advanced analysis supporting the rationale for the change in policy.

Examiners should review the credit union's system of identifying, measuring, monitoring, and controlling concentration risk to ensure it is commensurate with the level of potential concentration risk exposure.

If an examiner believes there may be elevated concentration risk issues present in a credit union, they should require corrective actions of management that include:

If management determines concentration risk is elevated, they should implement steps to mitigate the risk, such as:

The concentration of credit risk disclosure can be a complex issue, and banks may struggle to accurately assess their exposure to a particular borrower or industry.

Banks may not always have access to reliable information about a borrower's financial health, which can make it difficult to determine the level of credit risk.

A bank's credit risk can be concentrated in a single borrower or industry, making it vulnerable to significant losses if that borrower or industry experiences financial difficulties.

Banks may use internal models to estimate credit risk, but these models can be subject to biases and inaccuracies.

A bank's credit risk can be influenced by various factors, including the borrower's credit history, industry trends, and economic conditions.

Banks are required to disclose their concentration of credit risk in their financial reports, but the level of detail may vary.