Chapter Five: Pillar 2 Requirements of Basel Accords

Part Four: Concentration Risk Management

First: General Framework

1. Introduction

In the context of the Central Bank of Egypt's efforts to strengthen the Egyptian banking sector and enhance its efficiency in facing potential financial crises through the application of international best practices in banking supervision, including Pillar 2 of the Basel Accords regarding the Supervisory Review Process (SRP), which aims to cover other fundamental risks not considered under Pillar 1, such as concentration risk, non-trading book interest rate risk, liquidity risk, and ensuring the availability of sufficient additional capital to meet these risks.

In light of the above, it has been decided to apply the following instructions regarding concentration risk, which are considered one of the main causes of losses that may significantly impact bank performance and threaten its continuity in conducting its business.

These instructions include both qualitative requirements for managing concentration risk in all its forms and quantitative requirements for measuring credit concentration risk only, with banks required to comply with these requirements (qualitative and quantitative) as a minimum for managing all types of their concentration risks.

2. Scope of Application

1/2 These regulatory instructions apply to all banks operating in the Arab Republic of Egypt, including foreign branches. Credit concentration risk shall be measured on an individual basis (for individual banks and branches of foreign banks, both domestically and abroad) and on a consolidated basis for banking groups. Banks must report to the Central Bank of Egypt quarterly, within 20 days from the end of each quarter.

2/2 The Central Bank of Egypt requires all banks to assess concentration risk arising from all other risks they hold, such as funding, liquidity, and operational risks, in order to manage all types of concentration risk related to the bank's various activities. This requires conducting periodic stress tests for concentration risk. The bank's assessment of concentration risk in all its aspects is an integral part of the Internal Capital Adequacy Assessment Process (ICAAP), which is subject to supervisory review and evaluation (SREP) by the Central Bank of Egypt within the framework of implementing Pillar 2 of the Basel Accords.

3/2 Banks may apply internal methods for measuring concentration risk other than the regulatory method approved by the Central Bank of Egypt, but solely for their internal risk management purposes and not for regulatory purposes. In this case, if the Central Bank of Egypt so decides, these banks must report the methodology used in these internal methods and their results.

Second: Basic Concepts

1. Definition and Types of Concentration Risk

1/1 Concentration risk arises from the bank's reliance in conducting its business on investments in limited activities, with a limited number of customers, or on limited sources for obtaining financing or any other services. Generally, concentration risk relates to different types of risks to which the bank is exposed, which may result in:

• Large losses that threaten the bank's ability to carry out its main activities and/or
• A fundamental change in the risk structure to the bank's detriment.

2/1 Regarding the types of concentration risk, they may arise from any of the following sources:

• Credit Risk: Arises from the concentration of the bank's investments with a single client and its related parties directly or indirectly (individual concentration) or the concentration of investments among groups of parties whose probability of default is linked to common factors (such as sectoral or geographic concentration, etc.), which may lead to significant potential losses threatening the bank's financial stability or its ability to carry out its main activities.

• Funding Risk: Arises from the concentration of investments in the trading book (for example, the bank's concentration in securities issued by a single issuer) or the concentration of balance sheet items in specific currencies.

• Liquidity Risk: Arises from concentration in a limited number of depositors, reliance on limited funding sources, or concentration in specific types of assets.

• Operational Risk: Arises, for example, from reliance on a single technological system, specific operational systems, or a limited number of external service providers (Outsourcing).

2. Methods for Mitigating Concentration Risk

Banks may use a set of tools that contribute to mitigating concentration risk, which may include, but are not limited to, a combination of the following:

• Internal Limits: Establishing a comprehensive limits system that includes internal limits for investments with a single client or the client and its related parties, reflecting the assumed risk level regarding concentration risk. Continuous monitoring of these limits is required to verify their appropriateness and permanent activation. For example, the bank may set limits for investments at the sector, country, or bank product level. Additionally, banks must identify, monitor, and set appropriate limits for interconnected investments, whether on or off-balance sheet.

• Portfolio Management: Actively and continuously monitoring and managing bank portfolios to enable adjustments to new activities to address and mitigate existing large concentrations or avoid future ones.

• Risk Transfer: Transferring credit risk to another party using a systematic method, either directly by selling assets (loans) or securitizing its loan portfolio, or indirectly by conducting hedging operations with other parties (through purchasing credit derivatives or obtaining guarantees or sureties).

• Holding Additional Capital: Maintaining additional capital (under Pillar 2) above the minimum regulatory capital requirement under Pillar 1 of the Basel Accords.

Third: Principles for Banks

Banks must comply with a set of qualitative requirements and principles specific to managing and controlling concentration risk in all its forms. These requirements and principles can be summarized as follows:

1/1 The bank must have a clear policy regarding concentration risk, forming a fundamental aspect of its general risk management framework. This policy must be accurate, documented, and approved by the Board of Directors. The policy must be subject to periodic review, taking into account any changes in the bank's acceptable risk level and its operating environment.

2/1 The bank must have appropriate internal procedures, including an effective information system to identify, measure, manage, monitor, and report on all types of concentration risk in accordance with its approved policies and limits. These procedures must align with the nature and complexity of the bank's activities.

3/1 The bank must establish an appropriate structure for permissible concentration limits within its internal policies and overall risk measurement and management frameworks, with special attention to risk areas for which the Central Bank of Egypt has not specified measurement methods and quantitative requirements. In such cases, procedures must be established to ensure the appropriate use of these limits and guarantee that they are not exceeded under any circumstances.

4/1 Based on the concentration limit structure established by the bank, sub-limits for investments must be set at the level of economic sectors, geographic areas, guarantees, and collateral, etc., as well as at the level of funding sources such as interbank rates and the number of depositors, within a funding policy aimed at achieving an acceptable level of diversification.

5/1 The bank must regularly and periodically:

• Conduct a detailed review of the risk environment surrounding its various sectors.
• Apply appropriate stress tests and analytical scenarios.
• Conduct a thorough review of the economic performance of current borrowers.
• Review the necessary credit authorities for new businesses and activities.
• Review the risk mitigation methods used and verify their legal validity and continuous implementation.
• Review the bank's funding strategy to ensure effective diversification in funding sources and maturities.
• Review the business strategy.

6/1 In managing its concentration risk, the bank must adopt appropriate methods to mitigate such risks, such as risk transfer and active, continuous monitoring and management of credit portfolios, or any other methods the bank deems appropriate.

7/1 The bank must build adequate additional capital, of high quality (from Tier 1 capital components), to cover concentration risk, within the Internal Capital Adequacy Assessment Process, approved by the Board of Directors. This must take into account qualitative aspects of concentration risk management, as well as stress test results, their implications, and management's ability to take effective corrective actions when necessary.

Fourth: Supervision and Control by the Central Bank of Egypt

1/2 The Central Bank of Egypt, through desk supervision, its reporting system, and on-site supervision, conducts a comprehensive assessment of concentration risk at banks in all its qualitative and quantitative aspects. This allows for comparisons between similar banks, enabling the Central Bank of Egypt to assess the soundness of risk management at banks.

2/2 The Central Bank of Egypt uses quantitative and qualitative indicators to assess the degree of concentration risk at banks and the bank's ability to actively manage these risks according to the Central Bank of Egypt's risk assessment system, taking into account the bank's policies, limits, and stress test results used for this purpose.

3/2 Within the Central Bank of Egypt's risk assessment system, banks that have exceeded limits and must undergo continuous review and/or are expected to hold additional regulatory capital, which may require specialized on-site inspection for this purpose, are identified.

4/2 If the monitoring process conducted by the Central Bank of Egypt through its various regulatory tools reveals a high volume of concentration risk and/or inadequate management of these risks, the bank is required to take a set of corrective measures regarding the level of concentration present, including:

• Reducing concentration risk and diversifying its portfolio, or
• Building additional capital, or
• Both of the aforementioned measures.

In addition to the aforementioned corrective measures, the bank must conduct the reviews mentioned earlier (in Section 5/1) more deeply.

5/2 In all cases, regardless of the Central Bank of Egypt's assessment, the bank must report any significant results related to concentration risk and any corrective measures it takes regarding concentration risk.

Fifth: Quantitative Methods for Measuring Credit Concentration Risk

In measuring credit concentration risk under Pillar 2 of the Basel Accords, all banks operating in Egypt must calculate Individual Concentration Risk regarding investments with a single client and its related parties, and Sectoral Concentration Risk regarding investments with parties whose probability of default is linked to their activity in the same economic sector (as detailed below). In all cases, banks must allocate additional capital to face credit concentration risk without taking any provisions or any type of guarantees into consideration, according to the quantitative methods to be followed as follows:

1. Individual Concentration Risk

1/1 Individual concentration risk arises from the concentration of the bank's investments with a single client and its related parties directly or indirectly. Banks must measure individual concentration risk using the Individual Concentration Index (ICI) method.

2/1 Banks must use the Individual Concentration Index method to measure individual concentration risk for both the corporate and retail investment portfolios and calculate the additional capital required for this purpose.

3/1 The Individual Concentration Index is calculated using the Herfindahl Index (HI) and the Adjustment Factor (AF) according to the following equation:

$$ICI = HI \times AF = \frac{\sum_{i=1}^{1000}x^{2}}{\left(\sum_{i=1}^{1000}x\right)^{2}} \times \frac{\sum_{i=1}^{1000}x}{\sum_{y}y} \times 100 = \frac{\sum_{i=1}^{1000}x^{2}}{\sum_{i=1}^{1000}x\sum y} \times 100$$

Where:

• X: Represents the total investments of the bank with the largest 1000 clients (considering the concept of client includes the client and related parties) or the total investments of the bank as a whole if the number of its clients is less than 1000 clients for corporate and retail portfolios, without deducting any provisions and without taking any type of guarantees into consideration.

• Y: Represents the total investments in both the corporate and retail portfolios, without deducting any provisions and without taking any type of guarantees into consideration. This balance includes all investments with corporate and retail clients, including discounted commercial papers, credit facilities, loans, debt instruments, shares, off-balance sheet items, and any other form of financial support.

Based on the result obtained from applying the previous equation, the additional capital required to cover credit concentration risk (as a deduction from capital requirements for credit risk for corporate and retail portfolios under Pillar 1) is determined according to Table No. (1) below, which shows the relationship between the Individual Concentration Index (ICI) and the capital required to cover individual concentration risk (through which the capital requirement value to cover individual concentration risk is calculated).

Individual Concentration Index (ICI) (%)	Capital Required (%)
0.0 < ICI ≤ 0.1	0
0.1 < ICI ≤ 0.2	2
0.2 < ICI ≤ 0.4	4
0.4 < ICI ≤ 1.0	6
1.0 < ICI ≤ 100	8

Table No. (1)

4/1 If the bank has a capital requirement for the largest 50 clients under Pillar 1 (capital adequacy standard), the following applies:

• If the capital requirement for the largest 50 clients under Pillar 1 is greater than the capital requirement to cover individual concentration risk under Pillar 2 for the largest 1000 clients (including the top 50 clients), only the capital requirement for the largest 50 clients under Pillar 1 is considered. In this case, the bank is not required to calculate an additional capital requirement to cover individual concentration risk under Pillar 2.

• If the capital requirement for the largest 50 clients under Pillar 1 is less than the capital requirement to cover individual concentration risk under Pillar 2, the capital requirement for the largest 50 clients under Pillar 1 is considered, and the bank is also required to build the difference between them under Pillar 2 as an additional capital requirement for individual concentration risk.

5/1 If the bank does not have a capital requirement for the largest 50 clients under Pillar 1 (capital adequacy standard), the full additional capital requirement to cover individual concentration risk under Pillar 2 is considered.

2. Sectoral Concentration Risk

1/2 Sectoral concentration risk arises from large concentrations among groups of parties whose probability of default is linked to their activity in a single economic sector.

2/2 Banks must use the Sectoral Concentration Index (SCI) method to measure concentration risk at the level of different economic sectors to determine the capital requirements needed to cover this type of risk, as detailed below. The scope for calculating the Sectoral Concentration Index must be the total investments of the bank with corporate clients distributed across the twenty (20) economic sectors specified by the Central Bank of Egypt as follows:

No.	Economic Activity	No.	Economic Activity
1	Real Estate and Rental Activities	11	Textile and Apparel Manufacturing
2	Agriculture, Forestry, and Fishing	12	Financial and Insurance Services (excluding banking services)
3	Food, Beverage, and Tobacco Manufacturing	13	Social, Administrative, and Educational Services
4	Wholesale and Retail Trade and Repair	14	Fishing Activities
5	Construction	15	Electricity, Gas, and Water Supply
6	Transportation Equipment Manufacturing	16	Oil and Gas Extraction, Refining
7	Hotels and Restaurants (Accommodation and Food Services)	17	Transportation, Storage, and Information Activities
8	Quarrying, Mining, and Excavation	18	Glass, Ceramic, and Building Materials Manufacturing
9	Chemical and Leather Product Manufacturing	19	Electrical, Home Appliance, and Metal Equipment Manufacturing
10	Metal and Iron Manufacturing	20	Other Manufacturing

3/2 The Sectoral Concentration Index (SCI) is calculated according to the following equation:

$$SCI = \frac{\sum_{i=1}^{20} x_i^2}{(\sum_{i=1}^{20} x_i)^2} \times 100$$

Where:

• X: Represents the value of investments specific to each of the specified sectors (20 sectors), without deducting any provisions and without taking any type of guarantees into consideration. This balance includes all investments with corporations, including discounted commercial papers, credit facilities, loans, debt instruments, shares, off-balance sheet items, and any other form of financial support.

Then, according to the previous equation, the square of investments for each sector is calculated individually and summed together, then divided by the square of the total investments of all corporate clients distributed across the specified twenty sectors.

4/2 Based on the result obtained from the previous equation, the additional capital required to cover sectoral concentration risk (as a deduction from capital requirements for corporate credit risk) is determined through Table No. (2) below, which represents the relationship between the Sectoral Concentration Index (SCI) and the required capital (through which the capital requirement value to cover sectoral concentration risk is calculated).

Sectoral Concentration Index (SCI) (%)	Capital Required (%)
0 < SCI ≤ 12	0
12 < SCI ≤ 15	2
15 < SCI ≤ 20	4
20 < SCI ≤ 25	6
25 < SCI ≤ 100	8

Table No. (2)

Stress tests are considered one of the essential tools for risk management at banks under Pillar 2 of the Basel Accords, which the bank must conduct for different types of risks.

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