Concentration Risk in a Sector Portfolio
Your branch has a loan book of KES 800 million. KES 320 million (40%) is lent to businesses in the hospitality sector within the same town, including four hotels, three restaurants, and a catering company. The largest single exposure is KES 60 million to a hotel group that also guarantees two of the restaurant loans. The branch's sector limit in the credit policy is 25% of the book. Tourism arrivals to the region have been flat, and a new highway bypass is expected to divert traffic away from the town centre within eighteen months. The branch manager argues the exposures are safe because each borrower is profitable and the loans are performing.
1. Quantify and explain the concentration risk, including the correlated default and contagion dimensions.
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The branch is running two overlapping concentrations that the manager's 'each borrower is profitable' argument ignores.
1. Sector concentration. Hospitality is 40% of an KES 800 million book = KES 320 million, against a 25% policy limit (KES 200 million). The excess is KES 120 million. Policy breach alone requires escalation.
2. Geographic and single-factor concentration. All borrowers are in one town exposed to the same driver - tourism and passing traffic. A single shock (the bypass, a tourism downturn, a road closure) hits every borrower at once. Individual profitability is irrelevant when defaults are correlated.
3. Name and guarantee linkage. The KES 60 million hotel group guarantees two restaurant loans. If the hotel group fails, the guarantees are worthless at the same moment the restaurants are stressed - the guarantee provides no real diversification. The effective single-name exposure is larger than KES 60 million.
4. Contagion. Hospitality firms share suppliers, staff, and customers. A failure of one can trigger unpaid trade creditors and reputational damage that pulls down others.
Conclusion: The portfolio is exposed to a common shock with no offsetting exposures. Expected loss under a downturn is far higher than the sum of individual probabilities of default would suggest.
2. Recommend a risk-mitigation plan that respects existing customer relationships while bringing the branch within policy.
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The plan must reduce concentration without triggering the very defaults it is trying to avoid.
1. Stop new hospitality lending immediately, and route any exceptions to credit committee with a documented rationale.
2. Reduce the excess gradually - target the KES 120 million over-limit through:
- Natural amortisation and non-renewal of short-term facilities.
- Encouraging performing borrowers to refinance or move part of their debt elsewhere.
- Selling down or participating out part of the largest exposures.
3. Address the guarantee linkage - treat the hotel group and the two guaranteed restaurants as a single obligor for limit purposes, and require the guarantees to be replaced or supported by independent collateral.
4. Diversify new business - actively grow exposures in sectors uncorrelated with tourism (e.g., agri-processing, logistics, healthcare) to dilute the ratio as the book grows.
5. Stress the portfolio - model the bypass and a tourism downturn, and set aside/provision for the incremental expected loss. Use the result to prioritise which exposures to reduce first.
6. Strengthen monitoring - quarterly reviews of all hospitality borrowers, early-warning triggers (falling occupancy, arrears, covenant breaches), and a watchlist.
7. Governance - report the breach and the remediation plan to the board credit committee, with a timeline and owner for each action.
Why this works: It reduces the numerator (hospitality exposure) and increases the denominator (diversified book) without abrupt withdrawal that would crystallise losses.