It makes no difference whether the assets are stocks and bonds held for investment purposes, financial instruments held and positions taken for trading purposes or loans. It is tempting to assume that the overall objective of credit management is to achieve the lowest level of expected credit losses for a given standard deviation or the lowest standard deviation for a given expected loss level. This fails to take account of the revenue side, however.
A simple example will suffice to illustrate how credit risk concentration may occur. Let us assume that we are a bank operating in one state that has made a large loan to a cement manufacturer which is the largest employer in the town in which it is located. To diversify the risk of being exposed to the cement industry we also have many loans to real estate companies and to retail customers such as mortgages, car loan and credit cards. If the cement manufacturer fails this may start a chain reaction:
First we have the default on the loan to the cement company. But it will also lead to many people losing their jobs. We are at the risk of these individuals who are our customers being unable to make their mortgage, car loan and credit card payments. It will also lead to credit losses and loss of business at its suppliers. If the cement manufacturer is the town’s major employer the retailers will be adversely affected. This increases the risk that they will fail. In turn this increases the risk that property
investors who have borrowed to fund the retail mall will fail. Property prices are likely to fall as will our collateral cover. The bank can foreclose on lenders that had defaulted but could face realizing significantly lower recovery rates than originally expected from selling into a falling and illiquid property market.