What is meant by concentration risk?

Question

What will be an ideal response?

Answer 1

Concentration risk refers to a situation where a few borrowers of significant size are concentrated in a pool. This results in a loss of diversification and higher default risk. More details are given below.

Analysis of the credit quality of the collateral depends on the asset type. The rating companies will look at the borrower's ability to pay and the borrower's equity in the asset. The latter will be a key determinant as to whether the borrower will default or sell the asset and pay off a loan. The rating companies will look at the experience of the originators of the underlying loans and will assess whether the loans underlying a specific transaction have the same characteristics as the experience reported by the issuer.

The concentration of loans is examined. The underlying principle of asset securitization is that the large number of borrowers in a pool will reduce the credit risk via diversification. If there are a few borrowers in the pool that are significant in size relative to the entire pool balance, this diversification benefit can be lost, resulting in a higher level of default risk. This risk is called concentration risk.In such instances, rating companies will set concentration limits on the amount or percentage of receivables from any one borrower.