This lesson examines the principles of portfolio construction, diversification, and the management of concentration risk.

7.1 Principles of Portfolio Construction
Credit portfolio management involves the systematic management of a portfolio of credit exposures to optimise risk-adjusted returns . Key principles include:

  • Diversification: Spreading risk across a range of borrowers, sectors, and geographic regions to reduce concentration risk .

  • Correlation Analysis: Understanding the interdependence of defaults and credit migrations across exposures .

  • Setting Risk Appetite and Limits: Defining acceptable levels of risk for the portfolio .

7.2 Portfolio Diversification Strategies
Diversification is a primary tool for managing portfolio risk. Strategies include:

  • Sector Diversification: Avoiding over-concentration in any single industry sector.

  • Geographic Diversification: Spreading risk across different geographic regions.

  • Borrower Diversification: Limiting exposure to any single borrower or group of connected borrowers.

  • Product Diversification: Spreading risk across different types of credit facilities.

7.3 Concentration Risk Management
Concentration risk arises when the portfolio has excessive exposure to a single borrower, sector, or region. Concentration risk is a major concern for regulators and a key focus of portfolio management . Management strategies include:

  • Setting Concentration Limits: Defining maximum exposure limits for individual borrowers and sectors.

  • Portfolio Monitoring: Regular review of the portfolio to identify emerging concentrations.

  • Stress Testing: Assessing the impact of adverse scenarios on concentrated exposures.

7.4 Economic Capital and Capital Allocation
Economic capital is the amount of capital a financial institution needs to hold to cover unexpected losses from credit risk at a given confidence level . Key aspects include:

  • Capital Allocation: Allocating capital to different business units and portfolios based on their risk profiles.

  • Capital Adequacy Assessment: Ensuring capital is adequate to cover risks under the Basel framework .

  • Portfolio Optimisation: Using capital allocation to optimise the risk-return profile of the portfolio.

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