Banco de Portugal Instruction No. 2/2010 on Concentration Risk

Banco de Portugal Instructions
Instruction No. 2/2010
SUBJECT: Concentration Risk
Concentration of risks constitutes one of the main potential loss factors to which a credit institution is subject. In a concentration scenario, losses originating from a reduced number of exposures can have a disproportionate effect, confirming the importance of managing this risk in maintaining adequate solvency levels. Considering the importance of adequate concentration risk management by credit institutions and investment firms; Considering that concentration risk is not limited to the regulatory concept of large exposures; Considering that concentration risk, normally associated with credit risk, can manifest in other risks; Considering the importance of conducting stress tests on concentration risk, with emphasis on tests of the effectiveness of risk mitigation strategies in stress situations, especially because the net exposure amount associated with some counterparties (mainly those that are highly leveraged) can grow abruptly in the presence of severe shocks; Considering desirable and necessary the creation of information reporting in this area, consistent with the reporting requirements defined in Banco de Portugal Instruction No. 15/2007 on the Internal Capital Adequacy Assessment Process; Taking into account the provisions of Decree-Law No. 104/2007, of April 3, which transposes into Portuguese law Directive No. 2006/48/CE, of the European Parliament and Council, of June 14, 2006, concerning the access to the activity of credit institutions and its exercise, in particular, the provisions of Article 28, which establishes that credit institutions must have sound, effective and complete strategies and processes to assess and maintain on an ongoing basis the amounts, types and distribution of internal capital that they consider adequate to cover the nature and level of risks to which they are or may be exposed; Furthermore, taking into account the provisions of Article 116-A of the General Regime of Credit Institutions and Financial Companies (hereinafter RGICSF), which establishes that the Banco de Portugal must analyze the arrangements, strategies, processes and mechanisms applied by credit institutions to assess the risks to which they are or may be exposed; Taking into consideration the guidelines defined by the Committee of European Banking Supervisors (CEBS) on concentration risk, without losing sight of the fact that their implementation plan may lead to additional guidelines on this matter; Bearing in mind that regulatory requirements should not condition the development of internal practices in the analysis and management of concentration risks; Considering, also, the principle of proportionality, which takes into account the size, systemic importance, nature, level and complexity of the activities of the institution in question; Finally, taking into account the heterogeneity and diversity of techniques and their respective degree of complexity of the practices followed by institutions; The Banco de Portugal, in the exercise of
the competence attributed to it by Article 120 of the RGICSF, determines the following:

I. Scope of Application

1. This Instruction is applicable to credit institutions and investment firms, as well as to branches in Portugal of credit institutions or investment firms headquartered in countries that are not members of the European Union, hereinafter referred to as institutions, in accordance with Articles 3 to 5 of Decree-Law No. 104/2007 and Article 4 of Decree-Law No. 103/2007, both of April 3.
2. Compliance with the provisions of this Instruction must be carried out on a consolidated basis or, in the case of institutions not included in the scope of consolidation, for supervision purposes, of a financial group, on an individual basis. Notwithstanding, the Banco de Portugal may analyze, on a case-by-case basis, any exceptions related to the scope of application of this Instruction.
3. Although this Instruction focuses on credit concentration risk, institutions must have a clear and concise definition of what constitutes materially relevant risk concentrations for their activity, including concentrations of other risks besides credit risk (namely, market risk, liquidity risk, operational risk, business risk) and possible concentrations associated with simultaneous exposure to different, somewhat correlated risks (inter-risk concentration). Thus, the provisions of section II are applicable to all identified concentration risks.

II. Generic Aspects of Concentration Risk Management
4. Institutions must establish appropriate policies and procedures that allow for:
a) Defining and identifying concentration risks; b) Assessing and measuring different concentration risks; c) Managing, controlling, and mitigating concentration risks; d) Assessing internal capital needs taking into account the results of risk mitigation techniques applied in managing the level of concentration risk in their portfolios.
5. The policies and procedures referred to in the previous point must:
a) Be approved by the institution's administrative body; b) Be duly documented; c) Be subject to regular review, in order to accommodate changes in risk strategy and the business environment.
6. Within the scope of policies and procedures, institutions must establish appropriate exposure limits for concentration risks, which must be consistent with their overall strategy and risk profile.
7. Institutions must define procedures to ensure monitoring of compliance with the limits referred to in the previous point, as well as those applicable to situations where these limits are exceeded.
8. Concentration risk management policies must include measures to be adopted when the institution is confronted with concentration risk inconsistent with its risk profile. These measures may include:
a) A more detailed analysis of exposure to a given risk factor; b) The application of more sophisticated risk assessment methods and techniques, such as stress tests; c) More frequent review of the economic-financial performance and capacity of certain borrowers; d) Review of new credit approval policies; e) Review of the methods and techniques adopted for reducing concentration risks, with emphasis on aspects related to valuation and legal ties; f) Reduction of the limits referred to in point 6; g) Allocation of additional internal capital.
9. Within the scope of concentration risk management, institutions must also observe the provisions of Banco de Portugal Instruction No. 18/2007, related to stress tests. In particular, the effectiveness of mitigation strategies applied mainly in stress situations must be tested, as well as their implication in terms of resulting internal capital needs.
10. Institutions must explicitly consider their concentration risk, as defined in points 3 and 13, in the internal capital adequacy assessment process, and maintain an adequate level of own funds to cover concentration risk, in accordance with that assessment and the mitigation techniques applied. In this process, institutions must carry out an assessment of the quality of risk management and other internal systems and controls, including the ability to adjust between concentration levels and stress test results.
11. Notwithstanding the provisions of the preceding points, the monitoring of concentration risk by institutions must reflect their characteristics, in particular their nature, complexity, scale, and degree of diversification.

III. Credit Concentration Risk
12. Credit concentration risk is understood as an exposure or group of exposures at risk with the potential to produce losses so high that they jeopardize the institution's solvency or its ability to maintain its main operations. In particular, credit concentration risk arises from the existence of common or correlated risk factors among different counterparties, such that the deterioration of those factors implies a simultaneous adverse effect on the credit quality of each of those counterparties.
13. In accordance with the provisions of Decree-Law No. 104/2007, of April 3, there are three fundamental types of credit concentration risk:
a) Significant exposures to an individual counterparty or a group of related counterparties (“single name concentration risk” or “large exposures”). b) Significant exposures to groups of counterparties whose probability of default results from common underlying factors, such as: (i) the economic sector, (ii) the geographical region, and (iii) the currency. c) Indirect credit exposures resulting from the application of risk reduction techniques (exposure to a type of collateral or credit protection provided by a counterparty).
14. Without prejudice to the following points, the types of credit concentration risk mentioned in the sub-paragraphs of the previous point are subject to specific prudential treatment, respectively in Banco de Portugal Notice No. 6/2007, in the Banco de Portugal Recommendation on the concentration of risks in certain geographical areas, updated by Circular Letter No. 39/08/DSBDR, and in Banco de Portugal Notice No. 5/2007.
15. Institutions must select the indicators and metrics they consider most appropriate for measuring concentration risk, without losing sight of any limitations thereof. By way of example, the following are highlighted:

• In relation to a relevant measure/metric/component (e.g., balance sheet/asset size, own funds, net results):
• Relative weight of a certain number of the largest exposures (e.g., the 20/50/100 largest exposures, when relevant);
• Relative weight of the largest related exposures;
• Relative weight of the main sectoral/geographical concentrations;
• Exposure to a specific financial instrument (indirect exposures to a single collateral or type of collateral associated with risk mitigation techniques);
• Concentration/diversification indices and other related indicators (e.g., Gini coefficients, concentration curves).
  In the case of institutions that use economic capital models, which normally consider concentration risk implicitly, model risk should not be neglected.

IV. Submission of Information to the Banco de Portugal and Publication
16. Institutions must annually submit the information contained in the Annex to this Instruction, by the end of June.
17. The information contained in the previous point may be used for the purposes of the Internal Capital Adequacy Assessment Process (Banco de Portugal Instruction No. 15/2007).
18. Institutions must publish all relevant information on concentration risk, taking into account the general objectives and rules provided in Banco de Portugal Notice No. 10/2007.
19. This Instruction revokes Banco de Portugal Instruction No. 17/2007, entering into force on the date of its publication.