Quantifying Credit Portfolio’s Economic Capital for Evaluating Banks’ Risk Adjusted Performance Evidence from Saudi Arabia

Abstract

The study aims to quantify the economic capital necessary to absorb credit risks and calculate risk adjusted returns on the economic capital using parameters of the probability of default (PD), the loss given defaults (LGD) and the exposure at default (EAD) according to the foundation internal rating- approach under the second pillar of Basel ii and compare the results with the regulatory capita according to the standardized approach under the first pillar of Basel ii.  The study used the case study method to estimate the economic capital model for Bank AlJazira for the period 2018-2022. The study used R software programming language and Monte Carlo Simulation to generate the parameters   of value at risk (VAR). The study used the estimated parameters of the expected losses and the unexpected losses to develop risk adjusted returns on the economic capital. The results showed that the estimated expected losses were greater than the actual allocations for loan losses calculated by the bank, .i.e., the bank was under provisioning. However, the bank‘s regulatory capital under the Standardized approach was greater than the estimated economic capital, i.e., the bank was over capitalized. In addition, the results of the risk-adjusted return based on the outputs of the economic capital model indicated that the bank achieved negative returns during some years. While the results of the risk-adjusted return on the regulatory capital indicated positive results during the study period. In general, the results indicated that the economic capital model under the foundation internal rating- based approach generated expected losses greater than the allocations for loan losses, while the model generated risk capital less than the regulatory capital under the standardized approach which generated large regulatory capital. Therefore, it can be concluded that the regulatory capital is greater than the economic capital because it focuses on protecting depositors and creditors against the risks of default, while the economic capital focuses on measuring the risk capital from the perspective of shareholders. The results of the study will be useful to academics, practitioners and regulatory authorities.