Apologies for the long silence. I was in the office for two days in early June but then was back on the road until June 22.

Regarding Santosh’s latest inquiry, it seems to me that the vital role of concentration in risk analysis has been generally accepted for over 50 years. The early work of Harry Markowitz on modern portfolio theory can be traced as far back as 1952. For all the controversy it engendered, the work of Markowitz and his co-Nobel Prize winners William Sharpe and Merton Miller drove home one crucial idea. Financial risk is inherently a portfolio concept. The risk of any individual position is meaningless in the abstract without reference to its portfolio context.

I would argue that lack of explicit treatment of concentration risk is the biggest shortcoming in the Basel II credit risk framework. By explicitly assuming broad diversification, the framework ignores this central source of risk, especially extreme tail risk. Careful treatment of diversification is a major difference between the Basel II framework and most internal credit risk portfolio models. Needless to say, this weakness of the Basel II requirements is not due to lack of understanding on the part of national supervisors or the Basel Committee. The problem is that the framework has been severely criticized for being too complex as it is. Introducing effective treatment of diversification involves a broad range of further issues that would magnify this existing complexity.

A logical expectation is that Basel III, when if emerges, will embody a significant move toward broad use of internal models. Clearly the Basel Committee felt that such models were not sufficiently advanced in 1999, when the Basel II Accord was first proposed, for them to proceed along the lines of the market risk amendment. (The situation was clearly different in the early 1990s when the Committee was considering amending the capital accord to cover market risk. The use of distributional analysis along the lines of Value-at-Risk was well advanced and widely practiced before the initial prescriptive proposal for treatment of market risk was proposed in 1993. Indeed, I argue it was this advanced state of internal practice that convinced the Committee to accept an internal models approach in April of 1995.) Now that the discussion around Basel II have dragged on for eight long years (and counting) credit portfolio models have advanced significantly in both analytical sophistication and in available market data to support objective analysis. It is very possible that if the Committee was starting discussions today, it might well consider inclusion of a far greater role for internal models. Doing so at this stage, however, would only extend application of the embarrassingly crude terms of Basel I still further.