22. However rigorously banks and supervisors apply single debtor limits, there is always a risk that a bank will suffer from the simultaneous failure for similar reasons of a number of relatively large obligors. It may, in practice, be very difficult to prevent this in the case of small regional banks subject to depressed local conditions, but banks should nonetheless be made aware of the risks arising from the various forms of linkages and be encouraged to take what preventive action they can. In order to draw banks' attention to these risks and to provide supervisors with ancillary information for judging the extent of credit concentration, the introduction of a threshold reporting level below the absolute limit as indicated in paragraph 20 above would be very useful.
23. Where a bank has a "clustered" loan book, i.e. one which contains a relatively high proportion of sizeable single exposures, even if none of them are especially large, it is more exposed to potential credit risk than a bank with a more widely diversified portfolio. Much depends on the size, quality and range of the counterparties concerned, so it is difficult to suggest common guidelines for "clustering", but there is clearly greater potential for dangerous overall concentration if the limit on individual loans is 40% of capital than if it is 25% or less. If all exposures above 10% of capital are reported, as suggested in paragraph 20, the supervisor is in a position to judge each case on its merits and if necessary to see that additional precautions are taken.
24. In a similar vein, credit concentration can take the form of over-average exposure to particular economic or geographical sectors, making the lending bank vulnerable to a weakness in a particular industry or region. It is therefore important that banks systematically identify and measure their exposures to different sectors and regions so that the management is aware of the risks being run and can if necessary adjust the balance. It is not, however, sensible to suggest rigid rules since precise definitions are difficult and much depends on the expertise of the bank and the size and stability of the sector or region concerned. In addition, some banks are by their very location or by regulation obliged to concentrate their exposure to a certain degree. Nonetheless, prudence suggests that banks should diversify their exposure among different economic sectors as much as possible, avoiding excessive concentration in such areas as, for example, agriculture, energy, shipping, real estate, highly leveraged financing and industries vulnerable to movements in commodity prices. Experience shows that it is very difficult to predict what sectors might become vulnerable, so no sector should be regarded as exempt from the principle of diversification. One aspect of this problem is, of course, country risk, but even quite large banks have also learnt bitter lessons from over-exposure on a local or regional basis. 6
Footnotes
6. The EC Commission's Recommendation defines a large exposure for this purpose to be 15% of capital and suggests that their aggregate should not exceed eight times capital
