How is concentration risk measured with the Herfindahl index?

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AcadiFi · Accepted Answer

The Herfindahl-Hirschman Index in credit applies to obligor or industry exposures. For a portfolio with exposures w1, w2, ..., wN expressed as fractions of total, HHI = sum of wi^2. Values range from 1/N (equal weights) to 1 (full concentration in one obligor).

Example: Silvermark Lenders has a $600M corporate loan book split among three obligors: Aurora Tech $300M, Bastion Logistics $200M, Concordia Retail $100M. Weights are 0.50, 0.333, 0.167. HHI = 0.25 + 0.111 + 0.028 = 0.389. The effective number of equal-weighted names is 1/HHI = 2.57.

For industry concentration, compute HHI across industry buckets. A portfolio 40% real estate, 25% oil and gas, 15% tech, 10% healthcare, 10% other has HHI = 0.16 + 0.0625 + 0.0225 + 0.01 + 0.01 = 0.265.

Regulatory uses: the Basel IRB formula assumes infinite granularity. A granularity adjustment scales capital upward when HHI > 1/N threshold. The Pillar 2 supervisory review uses HHI benchmarks: HHI above 0.10 for single-name concentration flags elevated monitoring; above 0.18 often triggers additional Pillar 2 capital add-ons.

Limitations: HHI treats all counterparties as equally risky, ignoring PD and LGD differences. An HHI weighted by expected loss (wi * PDi * LGDi) better reflects true concentration. Also, HHI misses correlation effects - two separate obligors in the same supply chain effectively concentrate risk beyond what names-based HHI indicates.

How is concentration risk measured with the Herfindahl index?

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