CEBS today publishes its revised Guidelines on the management of concentration risk under the supervisory review process and Position paper on the recognition of diversification benefits under Pillar 2

The Committee of European Banking Supervisors (CEBS) today publishes the final text of its revised Guidelines on the management of concentration risk under the supervisory review process taking into the account the results of the earlier public consultation, which ran from December 2009 to March 2010.

The revised Guidelines replace the earlier version of the Guidelines on technical aspects of the management of concentration risk under the supervisory review process published on 14 December 2006 and complement the principles set out in the CEBS's Guidelines on the application of the supervisory review process (GL03).

Building upon the lessons drawn from the financial crisis, CEBS's revised Guidelines follow a holistic approach which aims at ensuring sound overall concentration risk management; this means that institutions are expected to identify and assess all aspects of concentration risk, moving further away from the traditional analysis related only to intra-risk concentration within the credit risk.

In its revised Guidelines, CEBS takes a broader approach to concentration risk management and suggest that there be an analysis of concentration risk not only within a risk type (intra-risk analysis), but also across risk types (inter-risk analysis), including credit, market, operational and liquidity risks. With respect to capital, institutions should take concentration risk into account in their assessment of capital adequacy under ICAAP, and be prepared to demonstrate that its internal capital assessment is comprehensive and adequate to the nature of concentration risk.

CEBS expects its members to apply the present Guidelines by 31 December 2010, meaning that by this date the guidelines should be transposed into national supervisory guidelines and reflected in the national supervisory manuals/handbooks, where applicable, and implemented in supervisory practices.

CEBS also expects institutions to make progress in implementing the Guidelines following the transposition and recommendations/requirements of national supervisory authorities, and to put in place implementation programmes aimed at ensuring timely/ compliance with the new Guidelines (e.g. gap analysis, implementation plans, etc.).

CEBS understands the potential for diversification benefits in institutions and the relationship with concentration risk on both an intra- and inter-risk basis. The quantification of concentration risk along with diversification benefits may be generated from the same or similar framework(s) or methodology(ies). Therefore, in addition to the Guidelines on concentration risk, CEBS has conducted an in-depth analysis of supervisory approaches to diversification benefits arising from economic capital models and publishes its findings in its Position paper on the recognition of diversification benefits under Pillar 2.

Although the existence of diversification benefits is accepted, given their inclusion under the regulatory Pillar 1 metrics of the Basel II capital framework, the extent to which they should be considered over and above their inclusion within the Pillar 1 models still appears to be questionable. Supervisors remain cautious about relying on methodologies developed by institutions for solvency and capital adequacy assessment purposes (including assessing and recognising diversification benefits).  This is due to the inherent difficulty of capturing the "real-life" loss distributions that give the correct probabilities of tail events.

Against this background and based on the comprehensive analysis summarised in the position paper, CEBS member authorities are taking a cautious stance towards accepting diversification benefits in the context of the SREP.

In particular, the recognition of intra-risk diversification benefits (within single risk type) should be subject to a number of conditions presented in this report, whereas the inter-risk diversification benefits (between various risk types) could only be accepted after an in-depth supervisory review, where the conditions elaborated in this report for intra-risk diversification have been fulfilled, and there has been a rigorous independent internal assessment and throughout review of the models used for calculation of diversification benefits.

Giovanni Carosio, chairman of CEBS, said:

"We are publishing both the concentration risk guidelines and the report on diversification perspective, as we see them, to some extent, as being two sides of the one coin. From a practical perspective, CEBS believes that improvements introduced to the institutions' risk management and measurement frameworks, aimed at better identification and mitigation of concentration risk as a result of the implementation of our guidelines, will also contribute to the evolution of measurement and modelling of the effects of diversification, which will then be addressed by supervisors in their reviews. We encourage institutions to consider further developments of their internal risk measurement and economic capital frameworks, making necessary improvements to their risk aggregation frameworks and methodologies."