What is concentration risk in finance?

Concentration risk in finance refers to the risk associated with having a significant portion of an institution's capital or earnings tied to a single exposure or a group of exposures. This can arise from lending to a single borrower, investing in a specific industry, or any other scenario where a large part of the portfolio is dependent on a limited number of assets or entities. Such risks are critical because if those specific exposures experience adverse events, it can have a profound effect on the overall financial stability and profitability of the institution. This risk highlights the importance of diversification in portfolio management, as concentration in too few areas may lead to substantial losses.

The other options describe different types of financial risks that do not specifically pertain to concentration. For instance, declining interest rates affect overall returns but do not focus on the specifics of having too much exposure in one area. Excessive diversification can introduce its own set of risks, notably diluting returns or diminishing control over investment quality, but it is not termed concentration risk. Lastly, inflation risks pertain to the erosion of purchasing power, which is unrelated to the concept of concentration risk specifically.