What is Concentration Risk and How to Reduce It?
Concentration risk is accepted, within multiple industries, as the probability of loss due to a large dependence on a single vendor, geographic area, or investment portfolio.
Lending organizations have dealt with concentration risk for years, out of concerns about lending too heavily to single borrowers, or within a single industry, and employ a “concentration ratio” calculation. In broad terms? The less diverse a lender’s loan portfolio, the higher its concentration risk.
But concentration risk has unique meanings within vendor risk management (VRM). Your organization might be unable to conduct business if operations or the supply chain are disrupted by one component in the greater machine. How can your organization manage concentration risk?
Examples of concentration risk
You must be aware of the different kinds of concentration risk in order to have an effective VRM program. Broaden your risk management focus to identify and manage these forms of concentration risk:
- Single vendor reliance, such as using only one vendor to support all deposit and loan core processing, trust, digital banking, and commercial lending.
- Asset concentration risk, when investors rely too much on a single investment or portfolio of different kinds of securities and asset classes.According to the Financial Industry Regulatory Authority (FINRA), “Mutual funds and exchange-traded funds (ETFs) can be helpful in achieving broad diversification.”
- Geographic/sectorial concentration of your high-risk or critical vendors, which can arise from a third party being in a region feeling the effects of geopolitical, weather, or civil unrest.
- Fourth-party concentration risk results from using multiple vendors’ inventory who all outsource services and production to the same fourth parties.
- Credit concentration risk occurs when loans are susceptible to a specific sector of the economy or business group that has slowed down, which is particularly risky for banks and financial institutions.
Companies should determine an acceptable amount of concentration of risk. This “risk appetite” is decided by the board of directors and C-suite, who establish policies that address concentration risk limits. Your board should consider the organization’s strategy, economic conditions, and net worth levels to set such limits.
VRM solutions can help identify and reduce concentration risk
The best way to manage concentration risk is to diversify your vendors. But how can you gather the necessary data to implement such a plan?
Utilize a VRM solution that has vendor analysis tools for managing and mitigating concentration risk. This will help you meet the guidance of your regulating bodies, including the FINRA. A solution should include generating reports with responses to questionnaires that are highly configurable and can be based on each individual vendor.
Unfortunately, questionnaires rely on the honesty and accuracy of human assessment. There’s also a chance your third-party vendors may not even know all their vendors or have the necessary information about them.
If you’re unsure of the reliability of questionnaires, find a VRM solution that also offers scorecards with a series of Business Impact Analysis questions. BIA scores report the risk of working with each vendor that is critical to your business. Vendors who have a high BIA score are the vendors you need to monitor more closely to assess their ability to maintain operations.
A geographical concentration risk feature map can also identify and gather critical location data and documentation for vendors. Custom and pre-built reporting features that can append critical data to your existing VRM tracking efforts are especially useful.
Safeguard your vendor network
Organizations are turning to VRM software solutions that offer functionalities to determine concentration risk, as well as provide analytical flexibility to create new levels of insight into vendor relationships. An automated, integrated, and simplified VRM solution ensures your organization isn’t putting all its eggs in a single – and potentially vulnerable – basket.