Concentration risk in financial institutions: The case for strategic balancing

By Francis OWUSU-ACHAMPONG (FCIB)

Banking business inherently involves managing various risks, requiring executives to carefully balance the pursuit of profits with sustainable growth.  Meticulous balance sheet management is crucial and involves detailed analysis of asset and liability composition, fund sources, tenors, effective costs, and profitability.

The Assets and Liabilities Committee (ALCO) plays a pivotal role in overseeing balance sheet movements. Proper management must go beyond ambition, avoiding the pitfalls of inexperience or recklessness.

This article explores the significance of strategic balancing and the implications of concentration risk in financial institutions.

Concentration risk arises when banks are disproportionately exposed to specific sectors or entities. This exposure can become problematic, especially if the sector’s or borrower’s financial health deteriorates.

A bank’s risk appetite and strategy should be anchored on its resources, ensuring a balance between liquidity and profitability.

The need to vary strategies continuously to meet the avowed objectives of returns on equity and assets, and ultimate sustainability cannot be left to amateurs or gambling inclined executives.

While ambition is a necessary driver for superlative performance, disregard for existing complexities in the assets and liability characteristics could spell doom for any financial institution, as would be elucidated in the next paragraphs.

A bank’s risk appetite and related strategy must be anchored on existing and potential resources at the bank’s disposal and how to ensure the finest balance between liquidity and profitability.

The desire for achievement naturally spurs individuals, businesses, and governments towards the realization of their ambitions, hence the varying degrees of risk acceptance or aversion.

For a bank’s board and management exercising fiduciary responsibilities to a multiplicity of stakeholders and facing corporate governance imperatives, each major decision must be carefully thought through.

Bullishness in banking expressed in an inordinate quest to grow too rapidly, must be tempered by the need to operate within clearly defined prudential measures, failure of which may draw the wrath of regulators.

What constitutes excessive ambition is however relative to the strengths and resources available to those charged with the responsibility to achieve certain goals within specific time frames.

A complex web of factors continually weigh in to make this oversight responsibility an arduous  exercise, premised on meeting regulatory guidelines, ensuring resilience and capacity to participate in the competition and assure shareholders and depositors of the safety of their investments.

The need for strategic balancing.

A key metric to assess whether strategies are on course is to ensure that prudential Capital Adequacy ratios are maintained within the requisite time frames. Irrespective of how bullish the board and management perceive opportunities in the market, this primary constraint cannot be ignored, lest the firm’s prospects will be imperilled.

The single obligor limit which represents the permissible exposure to a single entity by way of assets (25% currently in Ghana) is one of such key measures to manage concentration risk.

The Capital Adequacy Ratio is a prudential requirement imposed on banks in various jurisdictions aimed at ensuring the robustness of financial cushions for the stability of banking institutions.

Per the Basel Committee recommendations, banking regulators in advanced economies peg this at 8%, while in developing countries, a 10% threshold is required. Bank of Ghana requires an a buffer of 3% . The latter percentage was tactically suspended in the wake of the DDEP measures to provide the banks some respite. This has however been re-instated.

Understanding Capital Adequacy Ratio (CAR)

Formula:

CAR = Tier 1 Capital Tier 2 Capital × 100

Risk-Weighted Assets

?The Capital Adequacy Ratio (CAR) is a crucial measure of a bank’s financial health. It assesses its ability to withstand financial shocks by comparing its capital reserves to its risk-weighted assets, in both quantum and quality of these assets.  Regulators use this metric to ensure that banks hold enough capital to cover potential losses and maintain solvency.

Tier 1 capital relates to shareholder funds and accumulated reserves. Tier 2 capital refers to eligible or subordinated capital sanctioned by the regulator as not susceptible to volatile redemption clauses or ambiguous interest determination clauses.

Risk weighted assets refer to the aggregate of loans and advances discounted to reflect recovery prospects (loan loss provisions). Skewed asset concentration towards a particular sector or entity could spell doom when the sector’s or borrowers’ prospects decline.

A high capital adequacy ratio is typically viewed as a symptom of risk aversion but may be tactically accepted in the light of management perception of the direction of the economy.

A low capital adequacy ratio may also be a reflection of management’s optimism underlying its risk appetite and capital endowment.

What constitutes an optimum capital adequacy holding is obviously a matter for internal management analysis. This reflects its risk appetite and the country’s prevailing economic circumstances. Management’s view of what is optimal, as reflected in its internally generated economic capital computation, would also take cognisance of its market share and what their peer group’s indicators are. This must never fall below the regulatory capital lest they risk being sanctioned.

Generally, though, it is fair to state that too high a capital adequacy ratio reflects sub optimal use of resources or a high- risk aversion with its implications for lower return on capital. Conversely, a ratio below the Central bank’s minimum is a breach of regulation which may attract sanctions, including a fiat to scale down lending, sell assets or deepen deposit mobilization within a defined time frame.

Regulators in different jurisdictions determine what constitutes eligible capital and also the measures adopted for discounting or risk weighting specified assets (loans and advances).

Depending on what the central bank perceives as risks to a particular bank’s loans portfolio quality, it may apply its own measure in determining the discount factor to arrive at a risk-based value for the entire asset portfolio. The resultant effect could be a lowering of the CAR which will then come with stringent regulatory directives on how to restore normalcy.

The Central Bank may grant exceptional approval for a particular bank (upon application) to operate below the minimum capital adequacy ratio over a defined timeframe. This would occur where there are economic/sound reasons for temporarily breaching set guidelines, eg where the bank applies for dispensation to finance crude oil importation which has beneficial effect on the macro economy.

This would however come with prescriptions on the timeframe within which the bank must come back to normality, including other measures considered necessary to ensure that the bank’s solvency is not impaired over a long time.

Implications of Concentration risks

Compounding the board and management’s risk appetite is concentration risk. Different financial institutions operate in particular niche markets, usually based on their source of funding, internal expertise and perceived profitability of selected markets over time.

Business cycles do not remain static. Sectors grow and decline in line with market dynamics. For a country where economic growth indices are largely tied to uplifts in the oil and telecommunication sectors or tourism, the least change in country risk analysis, (internal security challenges, for instance) can cause a massive drop in growth. These sectors are particularly sensitive to economic fluctuations and negative investor sentiment. Borrowers in the sector face severe volatilities, causing financial difficulties and increased loan defaults.

This brings into sharp focus the peculiar risks faced by financial institutions whose fortunes are disproportionately tied to particular sectors or entities. Niche banking models have their peculiar vulnerabilities which must not be ignored while the bank regales in its comfort zone.

In the local financial market, reference could be made to the difficulties faced by GN Bank and its exposure to associated fund management firms. The latter indulged in excessive holdings of  government interim payment certificates which had been discounted in favour of various clients, in expectation of the government redeeming these instruments. When the government began to face fiscal difficulties, its capacity to pay up on these certificates was greatly impaired.

By extension, fund management firms which had invested disproportionately in these financial instruments faced catastrophic illiquidity. GN Bank which had supported its subsidiaries in this financing scheme suffered capital adequacy impairments, which among other issues caused the bank to collapse.

Another of the collapsed banks had its death knell invoked when it uncharacteristically financed the importation of crude oil for a customer who eventually defaulted in his loan repayments and significantly impaired the bank’s capital adequacy ratio.

Routinely, banks with heavy asset portfolios in agriculture are susceptible to loan repayment   hiccups when climatic changes affect agricultural output. The current drought reported in the northern parts of the country pose severe decline in food output and exposes the farmers and their financiers to grave difficulties. Related investments or exposure to food processing firms can result in similar difficulties.

Ghana Cocobod’s difficulties with declining cocoa output, impaired by unfavourable climatic conditions and perhaps, administrative weaknesses, have similar effects on financial institutions with heavy exposure in the cocoa sector.

Even at the local bank branch or departmental level in retail or corporate units, executives cannot be oblivious of the volatilities in their deposit holdings and asset classes. Various banks therefore adopt the Top 10 or Top 20 Depositors or Borrowers’ criteria in determining the levels of exposures to particular segments of the market or entities.

An imperative then arises to upscale relationship management skills in dealing with these critical creditors or borrowers so that their intentions could be known and managed to ensure some stability in the deposits and loans.

Banking executives with experience in the asset and liability management space cannot forget the effects of concentration risk on their balance sheets following the introduction of mobile money operations into the Ghanaian financial ecosystem.

A notable effect of this laudable financial inclusion model was the substantial liquidity it provided the Telcos which are involved in this scheme. Suddenly, most banks were disproportionately exposed on the liability side of their balance sheets with liquid resources that could easily be used as manipulative tools by the Telcos (as depositors) to influence money market rates, sometimes, defying the Bank of Ghana’s advertised prime rates.

The Telco firms’ aggregate liquidity clout also posed danger to exchange rate movements. They suddenly had the capacity to enter the forex market and substantially influence exchange rate determination from the demand side. With supply side rigidities, exchange rate determination was largely influenced by factors apparently out of scope of the central bank.

Given that almost all the commercial banks were subjected to such liability concentrations or exposures to a single sector of the economy, asset creation was unwittingly affected to the extent of widening mis-matches between short term deposits and relatively long term asset instruments created therefrom.

Under these conditions, liquidity challenges could be exacerbated by an asset-liability mismatch, where the bank’s liabilities (deposits) were predominantly encased in short-term instruments (ambiguous liquidity spectrum) while its assets were largely long-term and illiquid. Liquidating assets quickly enough to meet unexpected spikes in withdrawals, could lead to steep decline in the liquidity coverage ratio (LCR) and jolt banks in the money market.

Needless to admit, asset and liability management moved from intellectual analysis and board room strategies into corporate relationship management. Allegedly some reported underhand dealings by treasury operatives of the banks and the Telcos emerged, in the absence of which the banks faced difficulties in objective forecasting and budgeting.

Internationally, the collapse of Silicon Valley Bank (SVB) illustrates the dangers of excessive sector concentration. SVB’s focus on technology startups and venture capitalists led to vulnerabilities when market conditions shifted, resulting in a liquidity crisis and systemic disruption in the Us economy.

Sillicon Valley Bank (SVB) specialized in providing banking services to technology startups, life sciences firms, and venture capitalists. The bank’s strategic focus was on high-growth, high-risk sectors operating in an environment of low interest rates and by extension, the creation of then high rewarding assets to support firms in its niche market.

However, this specialization also brought in its wake distinctive sector specific vulnerabilities. In early 2023, SVB faced massive liquidity crisis that ultimately led to its collapse and caused systemic disruption across the financial markets.

The bank’s aggressive lending practices and investment strategies were anchored on the assumption of continued sectoral growth in the technology sector, amid favorable economic conditions prevalent at the time.

Market dynamics shifted substantially in 2023, especially with increasing interest rates and decline in the technology industry. This negatively affected SVB’s business model, which suddenly became unsustainable, with substantial holdings in low interest instruments. The bank’s collapse could largely be traced to a variety of factors, predominantly its specialised nature and excessive exposure to a distinct segment of the economy, with scant regard for diversification strategies.

This analysis underscores the importance of managing concentration risk in both assets and liabilities. Significant shifts in these areas can lead to liquidity and solvency issues. Banks must maintain traditional prudence and avoid excessive specialization or narrow focus to ensure stability and sustainable growth.

For those advocating for specialized banking institutions, such as Labour Union Banks or Women’s Bank, or a Union of Traders’ Bank, it is crucial to base such initiatives on a realistic assessment of the economy’s fundamentals.

If the fundamentals in the economy could be properly re-set, there would be enough opportunities for the existing twenty- three banks to meet the needs of any vibrant sector of this economy.

No bank executive would shy away from credit expansion if their capital,liquidity and internal capacities permit. To this writer, even the current 23 mainstream commercial banks are too many for this relatively small economy which has not changed significantly over the last sixty years and where bank’s liabilities virtually sit in the short-term domain.

The writer is a Fellow of the Chartered Institute of Bankers, a former adjunct Lecturer at the National Banking College, a farmer and the author of “Risk Management in Banking” textbook.

Email; [email protected]  Tel. 0244 324181

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