Estimating the Risk Capital under Basel Approaches to Develop a Credit Risk-Adjusted Return: Evidence from a Saudi Bank

Abstract

Abstract:

The study aims to quantify the risk capital, also known as economic capital, required to absorb credit risks and calculate credit risk-adjusted returns on this capital, using the parameters of the probability of default, loss given default, and exposure at default.  The study employed a case study method to estimate the risk capital model for a leading bank in Saudi Arabia, which adopted both the internal rating-based approach (IRB) and the Standardized approach, as the bank made the necessary disclosures for estimating the risk capital model for the period 2018-2022. The study utilized the R programming language and a Monte Carlo Simulation to generate the parameters of risk capital, which included both expected losses, measured by the average, and unexpected losses, measured by the tail distribution. The study used the estimated parameters of the expected and unexpected losses to develop credit risk-adjusted returns. The results showed that the estimated expected credit losses exceeded the actual allocations for loan losses calculated by the bank, indicating that the bank was under-provisioning for loan losses. However, the bank‘s regulatory capital under the Standardized approach was greater than the estimated risk capital. Therefore, the bank was over-capitalized. If both provisions for loan losses and regulatory capital are considered complementary, the bank is well capitalized. The study is original because it discusses the concepts of capital in banks, where regulatory capital is calculated according to the first pillar of the Basel I Accord, risk capital is calculated according to the second pillar of the Basel II Accord in parallel with regulatory capital, and then accounting capital is subject to accounting standards. Based on the study's results, it is recommended that banks adopt the concept of risk capital, allowing them to avoid holding excess capital at a high cost.