Understanding and Managing Concentration Risk in Supply Chains

Concentration risk in supply chains can be a major concern for businesses, as it can lead to significant losses if a key supplier or customer is lost. This is particularly true for companies that rely heavily on a single supplier or customer, such as those in the tech industry.

A single supplier can represent up to 90% of a company's purchasing spend, making them highly vulnerable to concentration risk. For example, in the automotive industry, a single supplier can provide up to 80% of the parts needed for a vehicle.

Companies can mitigate concentration risk by diversifying their supplier base and developing alternative sourcing strategies. This can involve identifying new suppliers, negotiating contracts, and implementing risk management plans.

Concentration risk is a risk that can threaten a financial institution's health or ability to maintain its core operations. It occurs when a single exposure or group of exposures has the potential to produce losses large enough to impact the institution's capital, total assets, or overall risk level.

A risk concentration can arise from too much reliance on any single product or service, which increases the potential for adverse consequences from event risk. Event risk refers to a negative event that significantly affects the financial condition of the institution.

Every asset, liability, product, service, and third party provider presents a risk of loss to the credit union under varying conditions or events. Some risks are less likely than others to occur.

Customer concentration risk is a specific type of concentration risk that stems from the potential loss of a customer that contributes a significant proportion of a company's total revenue. This risk can be mitigated by diversifying revenue streams and identifying the risk in each product or service line.

Concentration risk can arise from uneven distribution of exposures to borrowers, which is called name concentration risk. This type of risk can lead to significant losses if a single borrower defaults on a loan.

Concentration risk can also arise from uneven distribution of exposures to particular sectors, regions, industries, or products, which is called sectoral concentration risk. This type of risk can be exacerbated by economic downturns or market fluctuations.

Concentration risk can be present in many forms across credit union operations, including asset classes such as residential real estate loans, member business loans, automobile loans, loan participations, or investments.

Liabilities, such as rate sensitive share deposits or callable borrowings, can also be a source of concentration risk.

Third-party providers, such as CUSOs, indirect loan partners, or mortgage brokerage firms, can also pose a concentration risk.

Here are some examples of concentration risk in credit unions:

Real estate loans, member business loans, loan participations, construction and development loans, and investments in mortgage-related securities are all significant sources of concentration risk in credit unions.

Concentration risk is a significant concern for businesses and credit unions alike. It's identified and measured by performing a risk assessment that demonstrates understanding of the risk, quantifies potential loss exposure, and documents a rational business decision on the acceptable concentration level.

Management needs to perform a risk assessment for each product or service, which shows their understanding of the risk and potential loss exposure. This assessment is crucial for making informed business decisions.

The larger the concentration level, the more advanced the analysis and risk management techniques should be. For instance, a real estate portfolio that represents 20 percent of total loans requires less sophisticated analysis compared to one that represents 50 percent.

A credit union's risk management systems and analysis should be more robust for high concentration levels. For example, due diligence on a third-party service provider should be more thorough if the service is critical to the credit union's operations.

Credit unions must establish comprehensive data warehousing to track changes in their lines of business over time. This helps management make strategic and operational decisions in a safe and sound manner.

Customer concentration risk arises when a business is over-reliant on a few customers for a large portion of its revenue. This risk is material and can impact a company's revenue growth, profitability, and overall operating performance.

The loss of a single key customer can have a significant impact on a company's revenue and financial stability. Therefore, customer concentration risk must be closely monitored and kept at a manageable level.

Credit unions and businesses must regularly review and assess their concentration risk to ensure it remains within acceptable levels. This includes monitoring their data and adjusting their risk management strategies as needed.

Maintaining accurate data and reporting is crucial for credit unions to effectively manage concentration risk. This involves having a quality control function to ensure that data entry and changes are accurate and timely.

Data should be warehoused in a system capable of handling various lines of business, commensurate with the credit union's size and complexity. For example, this would include maintaining information on loan type, interest rate, and collateral value.

A data processing system should also be able to track changes over time, such as loan type conversions or interest rate resets. This will help identify potential concentration risks.

Credit unions should have a data processing system capable of maintaining information on loan type, interest rate, interest rate reset dates, payment amount, payment shock, credit score, collateral description, and collateral value. If not, management should contract with a third party to provide data warehousing and reporting.

Reporting must be periodic and timely, clearly indicating changes in concentration risk. The frequency of reporting should be commensurate with the type and size of the concentration, with larger portfolios requiring at least quarterly reporting.

Managing concentration risk requires a proactive approach. Implementing sound risk management practices is the key to managing concentration risk.

Regular monitoring and reporting are essential to assess concentration areas and identify elevated thresholds. This involves frequent and diligent reporting to assess concentration risks across various concentrations.

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 these limits. The parameters set by the board should be specific to each portfolio and include limits on loan types, share types, third-party relationship exposure, etc.

Here are some key steps to managing concentration risk:

Regular formal reporting to the board and senior management on compliance with concentration and risk limits is essential.

Managing concentration risk is a top priority for financial institutions and credit unions. The board of directors must establish a policy that addresses its philosophy on concentration risk.

The policy should include limits commensurate with net worth levels and the rationale for how the limits fit into the overall strategic plan of the credit union. This policy should be developed with a global perspective, considering outside forces such as economic uncertainty.

The board should not set concentration risk limits too high, as this can lead to significant losses when market conditions change. For example, starting or expanding a mortgage program with high loan-to-values during a real estate bubble is a recipe for disaster.

The parameters set by the board should be specific to each portfolio and include limits on loan types, share types, third-party relationship exposure, and other relevant factors. These risk limits should be closely linked to other policies, such as real estate loan, member business loan, and asset/liability management policies.

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

The board of directors must monitor concentrations that exceed 100 percent of net worth carefully and document an adequate rationale for undertaking that level of risk. This is crucial to maintaining a safe and sound financial institution.

Contingency planning is a crucial step in managing concentration risk. It involves preparing for potential disruptions in your supply chain, such as the loss of a key supplier or a disruption in the supply chain.

To get started, you need to assess the criticality of your suppliers. This involves examining their importance to your business performance and operations, as well as their location and level of reliance on fourth parties.

An inherent risk assessment can help you automatically tier suppliers, set levels of further diligence, and determine the scope of ongoing assessments. This assessment should consider factors such as supplier location and level of reliance on fourth parties.

You should also assess top-tier supplier business resilience and continuity plans based on an industry standard like ISO 22301. This will help you categorize suppliers according to their risk profile and criticality to the business.

Key steps in this assessment include categorizing suppliers according to their risk profile and criticality to the business, outlining recovery point objectives (RPOs) and recovery time objectives (RTOs), and ensuring consistent communications with suppliers during business disruptions.

Here are the key steps to categorize suppliers according to their risk profile and criticality to the business:

By continuously monitoring for supplier events, you can get ahead of potential disruptions and stay on top of your concentration risk.