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FRM Part II · FRM Exam Part II

Basel III: Finalising Post-crisis Reforms for FRM Part II

Basel III finalisation is the 2017 package that revises how banks measure risk-weighted assets. It changes the standardised credit approach, limits internal models with input and output floors, replaces earlier operational risk approaches with one standardised approach (BIC × ILM, ILM = 1 for smaller banks), revises CVA, and adjusts the leverage ratio. Identify the measure, then apply the rule.

What this chapter covers

This chapter covers the final set of Basel III reforms, often called Basel III finalisation. The main aim is to reduce unwarranted variability in risk-weighted assets (RWA) across banks and restore credibility to the capital ratio. Earlier rules let banks using internal models report very different RWA for similar portfolios. The reforms make the standardised approaches more risk-sensitive, constrain internal models, and set a floor linking the two.

The chapter has four working parts. Credit risk gets a revised standardised approach (SA) and a revised internal ratings-based (IRB) approach with input floors. Operational risk moves to a single standardised approach, built on the Business Indicator Component (BIC) and the Internal Loss Multiplier (ILM), supported by loss data and governance requirements. The Standardised Measurement Approach (SMA) was the 2016 consultative proposal, not the final name. CVA risk gets a revised framework that removes the internal-model approach (IMA-CVA) and uses the standardised (SA-CVA) and basic (BA-CVA) approaches. Finally, an aggregate output floor and leverage ratio revisions tie the package together.

This chapter links to the rest of Part II in several ways. It supports the credit risk topic, where PD, LGD and EAD feed IRB capital. It supports the operational risk topic, where loss data and governance matter. It also connects to liquidity and treasury risk through the leverage ratio and bank balance sheet constraints. Questions are usually applied: you may be asked which rule applies to a bank, or how a floor changes capital.

Regulatory capital is the thread running through a bank-risk exam, and this chapter is where Basel rules are stated precisely. Questions reward exact knowledge of which approach applies, what a floor does and why a reform exists. Many items are conceptual, so careful reading gains marks quickly. The material also reinforces credit and operational risk topics, so time spent here pays back across the paper.

Basel III: Finalising Post-crisis Reforms: topics in the order to study them

  1. 1Basel III Finalisation Overview and ObjectivesStart here to learn the aim of reducing RWA variability, which frames every later rule.
  2. 2Revised Standardised Approach for Credit RiskThe standardised approach is the base for the output floor, so you need it before the internal models.
  3. 3Revised Internal Ratings-Based Approach and Input FloorsOnce you know the standardised approach, you can see how the IRB restrictions and input floors limit model benefit.
  4. 4Standardised Approach for Operational Risk (BIC and ILM)Move to operational risk and learn how the single method replaces earlier approaches. Note that the SMA was the earlier 2016 proposal, not the final rule.
  5. 5Operational Risk Loss Data and Governance RequirementsLoss data feeds the ILM, so study it straight after the calculation logic.
  6. 6Credit Valuation Adjustment (CVA) Risk FrameworkCVA is a self-contained framework best studied once credit and counterparty ideas are fresh.
  7. 7Output Floor and Leverage Ratio RevisionsFinish with the floor and leverage ratio, which pull all the earlier approaches together.

How to prepare Basel III: Finalising Post-crisis Reforms

Treat this chapter as a set of rules with reasons. Learn what changed, why it changed and who it affects.

  1. Read the overview first and write the objective of the reforms in one sentence, so every rule has a purpose.
  2. Learn the standardised credit approach, then compare it with the IRB approach to see where floors limit model use.
  3. For each floor, note what it applies to: an input such as a parameter, or the output as total RWA.
  4. Study the operational risk standardised approach as a flow: the business indicator, the BIC, the ILM based on loss history, then the resulting capital. Link it to loss data requirements, and remember the SMA was the 2016 proposal.
  5. Write a short summary of the CVA framework and the leverage ratio changes, and revisit them after a day.
  6. Practise applied questions that ask which approach or rule applies, and explain why each wrong option fails.
  7. In the last week, redo only the questions you missed and recite the revision points aloud.

Common mistakes in Basel III: Finalising Post-crisis Reforms

  • Mixing up input floors and the output floor.

    Fix: Remember that input floors apply to parameters in the model, while the output floor applies to total RWA against the standardised result.

  • Assuming the reforms remove internal models entirely.

    Fix: State that models stay for many exposures but are constrained by restrictions and floors.

  • Treating the leverage ratio as risk-sensitive.

    Fix: Say it is a simple, non-risk-based backstop.

  • Recalling operational risk approaches from earlier Basel rules, or the 2016 SMA proposal, instead of the final standardised approach.

    Fix: Use the final standardised approach for operational risk (BIC and ILM) as the current method and link it to loss data.

  • Memorising rules without the reason for them.

    Fix: Tie every rule to the aim of reducing RWA variability and use that aim to eliminate wrong options.

Last-day revision: Basel III: Finalising Post-crisis Reforms

  • The finalisation aims to cut unwarranted RWA variability and restore trust in capital ratios.
  • The revised standardised approach is more risk-sensitive than the earlier version.
  • IRB use is restricted for some exposure classes, and input floors limit model parameters.
  • Input floors apply to the PD, LGD and CCF/EAD parameters; they do not cap total RWA. Separately, EAD must be at least the on-balance-sheet exposure amount, which is a distinct measurement requirement and not an input floor.
  • The output floor ties internal-model RWA to a share of standardised RWA.
  • The revised standardised approach (BIC × ILM) replaces earlier operational risk approaches with one method. ILM is 1 for banks with a Business Indicator up to €1bn, and national authorities may set ILM to 1 for all banks in their jurisdiction, so loss data matters mainly for larger banks. The SMA was the 2016 proposal name.
  • Loss data quality and governance support the operational risk standardised approach and are tested for process, not only numbers.
  • The CVA framework revises capital for counterparty credit spread risk on derivatives. It removes the internal-model approach (IMA-CVA) and uses the standardised (SA-CVA) and basic (BA-CVA) approaches.
  • The leverage ratio is a non-risk-based backstop to risk-weighted capital.
  • Read each question for the approach named: standardised credit, IRB, operational risk standardised (BIC and ILM) or CVA.

Basel III: Finalising Post-crisis Reforms practice questions

Basel III: Finalising Post-crisis Reforms in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Basel III: Finalising Post-crisis Reforms: frequently asked questions

What is Basel III finalisation?

It is the final package of Basel III reforms that revises how banks calculate risk-weighted assets. It covers credit risk, operational risk, CVA, the output floor and the leverage ratio.

Why do input floors matter?

They set minimum values for model parameters, so banks cannot use very low estimates to cut capital. This limits model-driven variability.

Do I need to memorise every number in this chapter?

Focus first on the logic and which rule applies to which risk. Learn key parameters from your reading, and check them against GARP's material.

How does this chapter connect to operational risk topics?

The operational risk standardised approach (BIC and ILM) and the loss data requirements link directly to operational risk measurement and governance. Studying them together helps in applied questions.