What does the Herfindahl index measure in a loan portfolio?

• A. Concentration of exposure across borrowers; lower implies more diversification.
• B. Average loan size.
• C. Average interest rate.
• D. Liquidity of the portfolio.

Answer: (A)

Concentration risk in a loan portfolio is what the Herfindahl index captures. You look at how exposure is distributed across borrowers by taking each borrower's share of total exposure (for example, their loan balances as a fraction of the total portfolio), squaring those shares, and summing them up. The resulting value tells you how evenly exposure is spread. If many borrowers carry similar, small shares, the sum is low, signaling diversification. If a few borrowers dominate the exposure, the sum is high, signaling concentration risk.

For context, think of two portfolios: one with many borrowers each with a tiny slice of the total exposure, and another with one or a couple of borrowers holding most of the exposure. The first will yield a small Herfindahl index, the second a large one, reflecting the higher risk from concentration.

This index is not about how large each loan is on average, nor about the interest rates charged, nor about how liquid the assets are. Those are separate concepts.