Concentration Risks in the Loan Portfolios of the German Savings

Contents

1 Introduction

2 The Regional Principle of Sparkassen and Credit Unions in Germany
2.1 Sparkassen
2.1.1 The Regional Principle of Sparkassen
2.1.2 The German Savings Bank group
2.2 Credit Unions
2.2.1 The Regional Principle
2.2.2 The Bundesverband Deutscher Volks- und Raiffeisenbanken (BVR)
2.3 Common aspects of both, Savings Banks and Credit Unions

3 Concentration risks in loan portfolios
3.1 Risk and concentration risk
3.2 Sources of concentration risks in loan portfolios
3.3 Methods to measure concentration risks
3.3.1 Methods to measure name concentration
3.3.2 Methods to measure sector concentration

4 Specialization and „diversification discount“
4.1 The trade off between specialization and diversification
4.1.1 The relationship between Specialization (Monitoring) and Diversification
4.1.2 The incentive to perform monitoring
4.2 Empiric evidence
4.3 Impact on Savings Banks and Credit Unions

5 Risk reduction via new financial products
5.1 Products for Credit Risk transfer
5.2 Specialization without to renounce on advantages of Diversification
5.2.1 Negative affects of „classic“ diversification
5.2.2 Diversification under the use of derivatives

6 Conclusion

7 References

List of Figures

Figure 1: Concentration risks in an overview

Figure 2: Effect of Diversification on Bank Return, Risk, and Performace

Figure 3: Products to transfer credit risk

List of Abbreviations

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1 Introduction

Risk Concentration in loan portfolios endanger the safeness of banks and reduce their profitability. Savings Banks and Credit Unions, as small banks which are specialized on geographic regions, are supposed to show high risk concentration in their loan portfolios and perform weakly.

This paper will analyse the consequences of the “Regional Principle“ of the German Savings banks and Credit Unions on the risk concentration in their loan portfolios. One main subject is to show the positive and negative impacts of both strategies, specialization and diversification, on risk concentration, and to explain under which circumstances a bank should decide to specialize or to diversify. Furthermore possibilities will be presented to profit from both strategies thanks to credit risk tranfer by new financial products.

The Regional Principle, its origin and and how it determines the strategy of Savings Banks and Credit Unions will be observed in the first part. Further I will explain why they can be considered as a homogenous group of banks. Within the second part will be presented the importance and the sources of concentration risks. Under which circumstances a Financial Institute should specialize or diversify, advantages and disadvantages and the trade off between both strategies will be presented in chapter three. As Savings Banks and Credit Unions would be better off within a regional diversification strategy, in chapter five will be presented the possibility of diversification under the use of derivatives and asset backed securities. Finally the paper will end with a conclusion considering results in wider context of Savings Banks and Credit Unions.

2 The Regional Principle of Sparkassen and Credit Unions in Germany

We first need to define the term ”Regional Principle“ of German Savings Banks and Credit Unions for to be able to analyse its consequences on risk concentration in Loan Portfolios. The term ”Regional Principle“ has its origin in municipal reglementation and is used mainly in the Savings Banks context. A legal definition of the expression does not exist in German Savings Bank law, nor in the municipal law.¹ For the purpose of this paper it is useful to abandon the law context and to define the term as follows. “Regional Principle“ expresses the market strategy of a bank, to operate only in a small (much smaller than “national“) market with the clear aim not to change the market size and to focus or specialize on financing firms, settled in the same region as the bank. As banks benefit from their access to international finanancial markets and because our focus is on loan portfolios, we apply the definition only on the asset side.

2.1 Sparkassen

2.1.1 The Regional Principle of Sparkassen

The Regional Principle of Sparkassen is historically determined by its character as institution, created and guaranteed by the „Gemeinde“, as the smallest self-governing institution in the state. The principle is indirectly fixed in the German Constitution: Art.

28 Abs. 2 Satz 2 GG. It is the right and the function of a Gemeinde to create and conduct Savings Banks. The operating area of a Savings Bank must thus be equivalent to the area of the Gemeinde². Further reglementation is given by the Sparkassengesetze of the different Länder. For example, the Sparkassengesetz of Baden-Württemberg regulates the foundation and direction of Savings Banks. In §6 of the Sparkassengesetz of Baden-Württemberg, the regional principle is ordered by law, for all Savings Banks in the Land Baden-Württemberg³. „Von diesem Regionalprinzip haben sich jedoch im Laufe der etwa 200 Jahre Sparkassengeschichte zahlreiche Ausnahmen entwickelt.⁴ “ For that reason, the region of a Gemeinde is no longer precisly equivalent with the district of a Sparkasse, but in general the Regional Principle maintained till this day. In Germany, there are 457 Sparkassen widespread all over the country.⁵ This empiric data shows, that the regional principle is still today the market strategy of Savings Banks. The very recent abolishment of „Anstaltslast and Gewährträgerhaftung“ did not have any impact on the Regional Principle.

2.1.2 The German Savings Bank group

The Deutsche Sparkassenfinanzgruppe compasses the Savings Banks, Landesbanken and Landesbausparkassen and many other member institutions. The group is characterised by a high business integration and its liability for the solvency of each Savings Bank, Landesbank and Landesbausparkasse.⁶ Until 2005 it was the Gemeinde which was liable for the debt of its Savings Bank. Recapitulatory, the Union has two functions: „assurance“ and „business-integration“. The Regional Principle, as we constated above, is conform with one single Savings Bank, but what about the effect of the existence of the Union? Is one Savings Bank independent enough to be considered as a credit institution for its own, or is it to be considered as a part of an enormous credit institution called Sparkassenfinanzgruppe? Answering this question would jeopardise the size of this paper. Although we need to answer it at least for one „department“: the credit portfolio. Each Savings Bank’s credits are in a portfolio which is independent and not directly interlinked with the other members and institutions of the Union. The Regional Principle determines thus the structure of the credit portfolio of a Savings Bank.

2.2 Credit Unions

2.2.1 The Regional Principle

As well as the Savings Banks, the Credit Unions were created for to ease the distress of the poor. There was a big lack of bank service offering for „the ordinary person“, who had little money to invest or who had a humble credit demand. The foundation of the first Unions goes back to Hermann Schulze-Delitzsch and Friedrich Wilhelm Raiffeisen.⁷

The „regional principle“ was never law given, as it was for the Savings Banks. The

wellfare aim, indirectly causes a focus on the regional market. Credit Unions are created to offer services, members could not receive without the union, or if there was an offering, they were created to offer services, superior to the services provided by other suppliers and/or to guarantee price advantages for members. Hence, market growth is not the aim of Credit Unions, but to create value for the members living in the Credit Unions‘ region. Because of the legal status, the Credit Unions after §1 Abs. 1 GenG must follow a so called „Förderungsauftrag“.⁸

2.2.2 The Bundesverband Deutscher Volks- und Raiffeisenbanken (BVR)

The Cooperation of German Credit Unions is organized very similar to the Savings Banks Union. The aim is to supply the member institutes with services, and to ensure the deposits of customers of every single Credit Union. The demonstration, of the applicability of the Regional Principle on Savings Banks, can be transfered on the Credit Union System. As the functions of the BVR are as well assurance and cooperation, the Regional Principle has great impact on the Loan Portfolio of a Credit Union.⁹

2.3 Common aspects of both, Savings Banks and Credit Unions

Savings Banks and Credit Unions show the same hierarchical structure. The single institutes are very small of size and have neither the opportunity nor the aim to grow. Both groups of banks show a complex system of business integration and have the same network to guarantee the customers deposits.

Especially the fact, that every single institute follows the Strategy of Regional Specialization is most important for later considerations. Further is it to analyse the impact of the stability network. The origin, the basic idea, the legal form, as well as many other characteristics are different, but for this paper, both groups can be considered as homogenous.

3 Concentration risks in loan portfolios

3.1 Risk and concentration risk

„Risk“ in general means nothing else than „uncertainty“. Talking about credit, risk in this context means only the downside part of the whole uncertainty, thus the risk to experience losses.¹⁰ As we cannot see into the future, real life will always bring uncertainty, and every person and institution will never be exempt from it, but considering portfolio theory, it is possible to reduce risk. Furthermore can risk be divided into two categories: Systematic and Idiosyncratic risk.

„Systematic risk represents the effect of unexpected changes in macroeconomic and financial market conditions on the performance of borrowers. Borrowers may differ in their degree of sensitivity to systematic risk, but few firms are completely indifferent to the wider economic conditions in which they operate. Therefore the systematic component of portfolio risk is unavoidable and only partly diversifiable. Idiosyncratic risk represents the effects of risks that are particular to individual borrowers. As a portfolio becomes more fine-grained, in the sense that the largest individual exposures account for a smaller share of total portfolio exposure, idiosyncratic risk is diversified away at the portfolio level. This risk is totally eliminated in an infinitely granular portfolio (one with a very large number of exposures)“¹¹

„The term “concentration risk” in the context of banking generally denotes the risk, arising from an uneven distribution of counterparties in credit or any other business relationships or from a concentration in business sectors or geographical regions which is capable of generating losses large enough to jeopardise an institution’s solvency.“¹² As stability of banks is most important for national economies, or the world economy, there is great interest in avoiding concentration risks. The given definition represents the micro, or single bank perspective of concentration risks (institution ’ s solvency). Taking the macro perspective, only a risk capable to trouble the whole economic system would be called concentration risk. If nothing is mentioned, we follow the micro perspective, as it is convenient for the analysis of concentration risks in loan portfolios of single banks. And we apply the definition only on the asset and not on the liability side.¹³

3.2 Sources of concentration risks in loan portfolios

Having explained the importance and systematic of risk concentration, the next step is now the identification of their sources. Fig. 1 divides concentration risks into four categories: Operational Risk, Liquidity Risk, Market Risk and Credit Risk. As examples for each category are given in Fig.1 and because our main interest lies in loan portfolios, we switch directly to the left box.

In fact, credit risk is the most important source of concentration risks.¹⁴ The sub division of Credit Risk in name concentration, sector concentration and concentration in micro contagion derives from the Basel II Rahmenvereinbarung.

Concentration risks in an overview:¹⁵

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Fig. 1

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¹ vgl. Raskin (2001), p. 34

² vgl. Nierhaus, Stern (1992), p. 11

³ vgl. Klüpfel,Gaberdiel,Gnamm (2001), p. 70

⁴ Schmidt (2002), p.105

⁵ vgl. Deutscher Sparkassen- und Giroverband (2007) p. 2

⁶ vgl. Deutscher Sparkassen- und Giroverband (2007) p.2

⁷ vgl. Aschhoff, Henningsen (1996) p. 19ff

⁸ vgl. Wagner (2004), p 23ff

⁹ vgl. www.bvr.de

¹⁰ vgl. Büschgen (2006), p. 790

¹¹ Basel Committee on Banking Supervision (2006) p.4

¹² Deutsche Bundesbank (2006), p. 36

¹³ vgl. Deutsche Bundesbank (2006) p. 36;

¹⁴ vgl. Deutsche Bundesbank (2006), p. 36

¹⁵ Deutsche Bundesbank (2006), p. 37