In the portfolio risk-factor frameworks that underpin both industry credit VaR models and the Internal Ratings-Based (IRB) risk weights of Basel II, credit risk in a portfolio arises from two sources, systematic and idiosyncratic. 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 partially diversifiable. Idiosyncratic risk represents the effects of risks that are peculiar to individual firms. As a portfolio becomes more and more fine-grained, in the sense that the largest individual exposures account for a smaller and smaller share of total portfolio exposure, idiosyncratic risk is diversified away at the portfolio level.
The model framework for the IRB approach assumes that (a) there is only a single source of systematic risk, and (b) bank portfolios are perfectly fine-grained. To the extent that either assumption is violated, IRB capital requirements may understate the true economic capital requirement. When there are material concentrations of exposure to individual names, there will be a residual of undiversified idiosyncratic risk in the portfolio. This form of credit concentration risk is sometimes known as granularity, and can be addressed via a granularity adjustment to portfolio capital as proposed by Gordy (2003) and refined by Martin and Wilde (2002). While well-understood in principle, in practice there may remain challenges in implementation. For example, credit risk mitigation activities may indirectly give rise to concentration of exposure to providers of credit protection, usually in the form of guarantees or credit derivatives.
Violations of the "single systematic factor" assumption may be more difficult to discern, and also more difficult to address. Within a large single market such as the United States or the European Union, the macroeconomic performance of different geographic regions may not be fully synchronised. Exposures in foreign jurisdictions are additionally subject to country-specific risks, including among others, transfer risk, social risk and legal risk. Similarly, different industries may experience different cycles. If so, then distinct geographic regions and industries ought to be represented by distinct (though possibly correlated) systematic risk factors. In this case, a bank may be overweight in exposure to some of these risk factors and underweight to others. The extent to which a single-factor model (and, by extension, the IRB risk weights) understates economic capital depends on both the degree to which the bank is unbalanced in its geographic and industry exposures and the extent to which geographic and industry risk factors are correlated with one another. This form of credit concentration risk is known as sectoral concentration. Development of analytical tools for adapting single-factor frameworks for sectoral concentrations is still at an early stage. Difficult practical issues arise as well, for example, on how the relevant sectoral factors can be identified empirically. Appropriate methodologies for the modelling and estimation of default dependence are essential ingredients for progress in this area.
Related to the problem of sectoral concentration, but as yet addressed within few portfolio credit risk models, is the idea of contagion through business links. Contagion has drawn significant attention in recent academic literature on dependence in credit risk. There is so far only limited empirical evidence on the importance of contagion in pricing and management of credit risk, and clearly this is a topic of important continuing research.