Journal of Credit Risk

Risk.net

Calculating capital charges for sector concentration risk

Cornelius Kurtz, Eva Lütkebohmert and Julian Sester

  • A new methodology is proposed to calculate capital charges for concentration risk.
  • Concentration charges are defined through the impact of a sector on the total portfolio loss curve.
  • Capital charges are calculated via Monte Carlo simulation or tractable analytical formulas.
  • Our methodology is highly suitable for calculation of capital charges for sector concentration risk under Pillar 2 of the Basel regulatory framework.
     

We propose a methodology to quantify capital charges for concentration risk when economic capital calculations are conducted within a multifactor Merton framework. The concentration charge is defined through the impact of the sector on the portfolio loss curve. We propose two ways of measuring this effect. The first method relies on Monte Carlo simulation but has the advantage of not requiring the calibration of additional parameters and, hence, is easily applicable to banks that perform simulations. The second approach is a tractable, analytical formula that provides an efficient approximation to the first method. The proposed approach implies a simple and intuitive allocation of the resultant capital charge and is highly suitable to calculate capital charges for sector concentration risk under Pillar 2 of the Basel regulatory framework.

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