Asymptotic Single Risk Factor (ASRF) model is used to derive the regulatory capital formula of Internal Ratings-Based approach in the new Basel accord (Basel II). One of the important assumptions in ASRF model for credit risk is that, the given portfolio is well-diversified so that one can easily calculate the required capital level by focusing only on systematic risk. In real world, however, idiosyncratic risk of a portfolio cannot be fully diversified away, causing the so-called concentration risk problem. This paper suggests the simulation-based approach for measuring concentration risk using bank capital dynamic model. This approach is especially suitable for a portfolio with relatively small to medium number of obligors and relatively large-sized loans.

In recent years, many important advances have been made in modeling credit risk of a portfolio. One of them is Asymptotic Single Risk Factor (ASRF) model, which is used to derive the regulatory capital formula of Internal Ratings-Based approach in the new Basel accord (Basel II).

Under the ASRF framework, there are only two sources of risk: systematic risk and idiosyncratic risk. As the number of obligors in a portfolio increases, idiosyncratic risk is diversified away, so its contribution to portfolio risk disappears. Thus, one can easily calculate required capital level by focusing only on systematic risk under the ASRF assumptions. In real world, however, a bank's portfolio is often not sufficiently diversified. The fact that there are some large exposures in the portfolio implies that there is a residual of undiversified idiosyncratic risk in the portfolio. Under these circumstances, IRB formula in the Basel II underestimates the required regulatory capital. Some historical examples such as insolvency of Enron, Worldcom and Parmalat show the dangers of misunderstanding concentration risk (Deutsche Bundesbank, 2006).