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FRM Exam Part II · Basel III: Finalising Post-crisis Reforms

Basel III Standardised Approach for Operational Risk (SMA)

Updated 11 October 2026 · Fact-checked

The Basel III standardised approach for operational risk replaces all earlier methods. You compute the Business Indicator (BI), apply bucket marginal coefficients of 12%, 15% and 18% to get the BI Component (BIC), then multiply by the Internal Loss Multiplier (ILM). Capital = BIC × ILM; risk-weighted assets = 12.5 × capital.

Understand Standardised Approach for Operational Risk (SMA)

Operational risk capital under Basel II had three methods: Basic Indicator, Standardised and the Advanced Measurement Approach (AMA). Basel III finalisation removed all of them. Banks now use one standardised approach. The name Standardised Measurement Approach (SMA) comes from the 2016 consultation. The final framework (December 2017) calls it the standardised approach. AMA relied on bank-built models, which gave very different capital for similar banks. The new approach is simple and comparable.

The starting point is the Business Indicator (BI). It is an accounting-based measure of business size. It sums three parts: the interest, leases and dividend component (ILDC), the services component (SC), and the financial component (FC). Each component uses an average over three years. Larger banks with larger BI are assumed to carry more operational risk.

The BI is turned into the Business Indicator Component (BIC) with increasing marginal coefficients. The first €1 billion of BI carries 12%. BI above €1 billion and up to €30 billion carries 15%. BI above €30 billion carries 18%. Like tax slabs, each rate applies only to the slice in that bucket, not to the whole BI. Bucket 1 banks (BI up to €1 billion) have BIC equal to 12% of BI.

The last step is the Internal Loss Multiplier (ILM). It adjusts BIC for the bank's own loss history. It uses the Loss Component (LC), which is 15 times the average annual operational losses over the previous 10 years. Banks subject to the ILM must use 10 years of good-quality loss data, but 5 years is acceptable when the standard is first applied. If a bank does not have even 5 years of good-quality data, the supervisor decides the treatment. The supervisor may require a lower data threshold or set ILM = 1. A bank with high past losses relative to BIC gets ILM above 1 and holds more capital. A bank with low losses gets ILM below 1 and holds less. For bucket 1 banks, ILM is set equal to 1, so capital equals BIC. National supervisors may also set ILM to 1 for all banks in their jurisdiction.

You must also know what changed from AMA. AMA used internal models and could not be used under the final framework. The new approach is non-model-based, uses BI plus loss data, and its capital is multiplied by 12.5 to give operational risk-weighted assets that enter the total RWA.

Key formulas to remember

Business Indicator
BI = ILDC + SC + FC
Each component is a three-year average.
Interest, leases and dividend component
ILDC = min[ abs(Interest income − Interest expense), 2.25% × Interest-earning assets ] + Dividend income
The cap of 2.25% of interest-earning assets limits the interest part.
Services component
SC = max(Other operating income, Other operating expense) + max(Fee income, Fee expense)
Takes the larger side of each pair.
Financial component
FC = abs(Net P&L trading book) + abs(Net P&L banking book)
The absolute value of net P&L is taken separately for the trading book and the banking book, so a net gain or a net loss in each book increases BI.
BI buckets and marginal coefficients
Bucket 1: BI ≤ €1bn, 12%. Bucket 2: €1bn < BI ≤ €30bn, 15%. Bucket 3: BI > €30bn, 18%.
Coefficients are marginal: each applies only to the slice of BI inside the bucket.
BI Component
BIC = 12% × min(BI, 1bn) + 15% × [min(BI, 30bn) − 1bn]⁺ + 18% × (BI − 30bn)⁺
(x)⁺ means the larger of x and 0.
Loss Component
LC = 15 × average annual operational risk losses over the previous 10 years
Losses are net of recoveries and above the loss data threshold. Banks subject to the ILM use 10 years of good-quality data; 5 years is acceptable on first implementation.
Internal Loss Multiplier
ILM = ln( e − 1 + (LC ÷ BIC)^0.8 )
Equals 1 when LC = BIC. Above 1 when LC > BIC; below 1 when LC < BIC. Set to 1 for bucket 1. National supervisors may require ILM = 1. If a bank lacks even 5 years of good-quality data, the supervisor decides and may require a lower threshold or ILM = 1.
Operational risk capital and RWA
Capital = BIC × ILM; RWA = 12.5 × Capital
The 12.5 factor is the reciprocal of the 8% minimum capital ratio.

How to solve Standardised Approach for Operational Risk (SMA) questions

Work through the calculation in the same order every time. The question usually gives either BI or its components, plus loss data.

  1. 1Build BI. If components are given, add ILDC, SC and FC. Check the ILDC cap and use absolute values where required.
  2. 2Find the bucket. Compare BI with €1 billion and €30 billion.
  3. 3Compute BIC slice by slice with 12%, 15% and 18% on the part of BI in each bucket.
  4. 4If the bank is in bucket 1, stop: ILM is 1 and capital equals BIC.
  5. 5Otherwise compute LC = 15 × average annual losses over 10 years.
  6. 6Compute the ratio LC ÷ BIC, raise it to 0.8, add (e − 1), and take the natural log to get ILM.
  7. 7Capital = BIC × ILM. Multiply by 12.5 for RWA if asked.
  8. 8Sanity check: LC > BIC should give ILM > 1. LC < BIC should give ILM < 1.

Quickest way: Shortcut: use the direction of the ILM first

When to use it: When options differ clearly and you are short of time, or when the question asks only whether capital rises or falls.

  1. Compute BIC quickly. For BI between €1bn and €30bn use BIC = 120m + 15% × (BI − 1bn).
  2. Compute LC and compare with BIC. If LC = BIC, ILM = 1 exactly.
  3. If LC > BIC, remove any option giving ILM below 1. If LC < BIC, remove any option above 1.
  4. Only then compute the logarithm, using ln(e − 1 + x) where x = (LC ÷ BIC)^0.8.
  5. Remember ln(e) = 1, so e − 1 + 1 = e gives ILM 1 when x = 1.

Common mistakes in Standardised Approach for Operational Risk (SMA)

  • Applying one coefficient to the whole BI, such as 15% × BI for a €10 billion bank.

    Students treat the buckets as flat bands rather than slabs.

    Fix: Apply 12% to the first €1 billion, then 15% to the rest up to €30 billion, and so on.

  • Using BI of a single year.

    The question gives yearly data and students pick the latest.

    Fix: BI components use a three-year average unless the question says otherwise.

  • Forgetting the 15 multiplier in the Loss Component.

    Students use average annual loss directly in the ILM ratio.

    Fix: LC = 15 × average annual loss. Write it down before dividing by BIC.

  • Applying ILM to a bucket 1 bank.

    Students run the full formula for every bank.

    Fix: For BI up to €1 billion, ILM is 1 and capital equals BIC.

  • Confusing capital with RWA.

    The answer asks for RWA but the student stops at BIC × ILM.

    Fix: Multiply capital by 12.5 for operational risk RWA.

  • Saying AMA is still allowed or that SMA uses internal models.

    Basel II terms are mixed with the final framework.

    Fix: All earlier approaches, including AMA, are replaced. The new approach is non-model-based and uses BI and loss history.

Worked examples

Example 1

A bank has a three-year average Business Indicator of €12 billion. Compute its BI Component and say which bucket it is in.

Show the solution
  1. BI is above €1 billion and below €30 billion, so it is in bucket 2.
  2. First slice: 12% × €1 billion = €120 million.
  3. Second slice: BI above €1 billion is €11 billion. 15% × €11 billion = €1,650 million.
  4. BIC = €120 million + €1,650 million = €1,770 million.

Answer: Bucket 2; BIC = €1,770 million (€1.77 billion).

Example 2

A bank has BIC of €1,770 million and average annual operational losses of €118 million over the past 10 years. The bank is in bucket 2 and the loss data are used in the ILM. Compute the Loss Component, the ILM direction and the capital impact.

Show the solution
  1. LC = 15 × €118 million = €1,770 million.
  2. LC ÷ BIC = 1,770 ÷ 1,770 = 1.
  3. Raise to 0.8: 1^0.8 = 1.
  4. ILM = ln(e − 1 + 1) = ln(e) = 1.
  5. Capital = BIC × ILM = €1,770 million × 1 = €1,770 million.
  6. RWA = 12.5 × €1,770 million = €22,125 million.

Answer: LC = €1,770 million, ILM = 1, capital = €1,770 million, RWA = €22,125 million.

Exam tips

  • Write the bucket slices in a column. Slab-style errors are the most common loss of marks.
  • Check whether the question names bucket 1; if so, ILM is 1 and you save time.
  • When LC equals BIC, ILM is exactly 1. Examiners use this to make hand calculation easy.
  • Know the AMA versus SMA contrast: models and internal estimates versus a standard formula with BI and loss history.
  • Read the units. BI may be in € billions and losses in € millions.

Practice questions from Basel III: Finalising Post-crisis Reforms

Standardised Approach for Operational Risk (SMA) in other exams

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

Standardised Approach for Operational Risk (SMA): frequently asked questions

What is the difference between AMA and SMA for operational risk?

AMA let banks use their own internal models to estimate operational risk capital, which led to wide differences between banks. The standardised approach (called SMA in the 2016 consultation) uses a fixed formula based on the Business Indicator and the bank's loss history. It is simpler and more comparable, and AMA is removed under the final Basel III framework.

How do you calculate the Internal Loss Multiplier?

First compute the Loss Component as 15 times the average annual operational losses over 10 years. Then ILM = ln(e − 1 + (LC ÷ BIC)^0.8). If LC equals BIC, ILM is 1. Banks subject to the ILM use 10 years of data, with 5 years acceptable on first implementation. If a bank lacks 5 years of good data, the supervisor decides and may require ILM = 1.

What are the marginal coefficients for the Business Indicator buckets?

The coefficients are 12% for BI up to €1 billion, 15% for BI above €1 billion up to €30 billion, and 18% above €30 billion. They are marginal, so each rate applies only to the slice of BI in that bucket.

How do you turn operational risk capital into RWA?

Multiply the capital requirement, BIC × ILM, by 12.5. This is the reciprocal of the 8% minimum capital ratio and puts operational risk on the same footing as credit and market risk RWA.