FRM Exam Part II · Capital Regulation Before the Global Financial Crisis

Basel II Operational Risk Capital Approaches Explained

Updated 11 October 2026 · Fact-checked

Basel II offers three ways to set operational risk capital. The basic indicator approach charges 15% of average positive annual gross income over three years. The standardized approach applies 12%, 15% or 18% to eight business lines. The advanced measurement approach uses the bank's own model, with supervisory approval.

Understand Basel II Operational Risk Capital Approaches

Operational risk is the risk of loss from inadequate or failed internal processes, people and systems, or from external events. Basel II's definition includes legal risk but excludes strategic and reputational risk. Basel II was the first Basel framework to require an explicit capital charge for it.

Basel II gives banks three approaches, in rising order of sophistication: the basic indicator approach (BIA), the standardized approach (TSA) and the advanced measurement approaches (AMA). Simple methods need little data and suit smaller banks. More risk-sensitive methods need more data, better controls and supervisory approval.

Both BIA and TSA use gross income as a proxy for the bank's operational risk exposure. The idea is that a larger business tends to carry more operational risk. The weakness is that gross income is not a direct measure of risk. A bank with weak controls and low income gets a small charge, and a bank's charge can fall when income falls even if its risk does not.

Under TSA, gross income is split across eight business lines. Each line has a beta factor of 12%, 15% or 18%. Higher betas apply to lines seen as riskier. The charge is the three-year average of the yearly totals, where negative yearly totals are set to zero.

Under AMA the bank builds its own internal model. The model must be based on four elements: internal loss data, external loss data, scenario analysis, and business environment and internal control factors. The capital should cover a 99.9% confidence level over a one-year horizon. Expected loss may be excluded only if the bank can show it is adequately covered by provisions or pricing. Insurance mitigation is allowed but capped at 20% of the total operational risk capital charge.

Key formulas to remember

Basic indicator approach: K(BIA) = [Σ(GI₁…ₙ × α)] ÷ n, with α = 15%; GI is annual positive gross income over the previous three years. n is the number of years in which gross income was positive. Years with zero or negative income are excluded from both numerator and denominator.
Standardized approach: K(TSA) = {Σ over years 1-3 of max[Σ(GI₁₋₈ × β₁₋₈), 0]} ÷ 3; Within a year, negative income in one business line can offset positive income in others. If the year's total is negative, it counts as zero, and the zero stays in the denominator of 3.
Beta factors by business line: Corporate finance 18%; Trading and sales 18%; Payment and settlement 18%; Commercial banking 15%; Agency services 15%; Retail banking 12%; Asset management 12%; Retail brokerage 12%; Memorize the three groups. 18% for corporate finance, trading and sales, and payment and settlement.
Gross income: Gross income = net interest income + net non-interest income; Gross of provisions and operating expenses. Excludes realized profits or losses from the sale of securities in the banking book, extraordinary or irregular items, and income derived from insurance.
AMA standard: 99.9% confidence level, one-year holding period; Four required inputs: internal loss data, external data, scenario analysis, business environment and internal control factors.

How to solve Basel II Operational Risk Capital Approaches questions

Use this method for any Basel II operational risk capital question, numerical or conceptual.

1Identify the approach asked: BIA, TSA or AMA. If the question only says 'simple' or 'gross income based', check whether business line data is given.
2For a calculation, list the gross income for the three most recent years. Check each figure's sign.
3For BIA, drop any year with zero or negative income. Add the positive years, divide by the number of positive years, then multiply by 15%.
4For TSA, multiply each business line's income by its beta within each year and add the lines. Floor each yearly total at zero.
5For TSA, average the three yearly totals, dividing by 3 even if one year was floored to zero.
6For a conceptual AMA question, check the four elements, the 99.9% one-year standard, supervisory approval and the 20% insurance cap.
7Check units and currency, and convert the result to the form the options use (millions or billions).
8Check that your answer is sensible. If every business line has positive income in all three years, the TSA charge lies between 12% and 18% of average annual gross income. If a line is negative or a yearly total is floored at zero, the charge can fall outside that range. The TSA charge may be above or below the BIA figure, so do not assume they are close.

Quickest way: Beta-weighted shortcut for BIA and TSA

When to use it: Use when the question gives gross income by year or by business line and asks for the capital charge.

Decide BIA or TSA from the wording. Business line betas mean TSA.
For BIA, scan the three years for negatives first. This is the most common trap.
Compute the average before multiplying by 15%. It keeps the numbers small.
For TSA, work year by year. Do not average business lines across years first.
Eliminate options that divide by the wrong number of years, or use 15% in TSA for every line.
If asked which approach gives the lowest capital for a retail-heavy bank, think 12% betas.

Common mistakes in Basel II Operational Risk Capital Approaches

Dividing by 3 in the BIA when one year has negative gross income.
Students apply the usual three-year average without reading the exclusion rule.
Fix: In BIA, exclude non-positive years from both the sum and the count. In TSA, keep the floored zero in the divisor of 3.
Treating the BIA 15% as a beta applied by business line.
The 15% alpha and the 15% beta of some lines look similar.
Fix: Alpha is a single 15% for the whole bank under BIA. Betas of 12%, 15% and 18% apply to business lines under TSA.
Mixing up which business lines carry 18%.
Eight lines and three betas are easy to confuse.
Fix: Learn the groups: 18% for corporate finance, trading and sales, payment and settlement; 15% for commercial banking and agency services; 12% for retail banking, asset management and retail brokerage.
Flooring negative business line income at zero within a year under TSA.
Students copy the BIA exclusion rule.
Fix: Under TSA, negative income in one line offsets other lines in the same year. Only the yearly total is floored at zero.
Stating the AMA is a 99% one-year or 99.9% ten-day measure.
Confusion with market risk VaR parameters.
Fix: AMA uses a 99.9% confidence level over one year.
Believing AMA insurance can reduce capital without limit.
Students focus on risk transfer as a benefit.
Fix: Recognition of insurance is capped at 20% of the total operational risk capital charge, and the insurer must meet standards.

Worked examples

Example 1

A bank reports gross income of USD 400 million, USD 500 million and USD -100 million over the last three years. Using the basic indicator approach, what is the operational risk capital charge?

Show the solution

Exclude the negative year. Two years are positive, so n = 2.
Sum the positive years: 400 + 500 = USD 900 million.
Average over n = 2: 900 ÷ 2 = USD 450 million.
Multiply by α = 15%: 450 × 0.15 = USD 67.5 million.

Answer: USD 67.5 million.

Example 2

Under the standardized approach, a bank's three yearly gross income figures by line are: Year 1: trading and sales EUR 200 million, retail banking EUR 300 million. Year 2: trading and sales EUR -400 million, retail banking EUR 100 million. Year 3: trading and sales EUR 100 million, retail banking EUR 200 million. Betas: trading and sales 18%, retail banking 12%. Find the capital charge.

Show the solution

Year 1: 200 × 0.18 + 300 × 0.12 = 36 + 36 = 72.
Year 2: -400 × 0.18 + 100 × 0.12 = -72 + 12 = -60. The yearly total is negative, so floor at 0.
Year 3: 100 × 0.18 + 200 × 0.12 = 18 + 24 = 42.
Sum of the three years: 72 + 0 + 42 = 114.
Divide by 3, keeping the zero year in the count: 114 ÷ 3 = 38.

Answer: EUR 38 million.

Exam tips

Read the sign of every gross income figure first. Negative years are the favourite trap in BIA questions.
Know the difference between exclusion in BIA (removed from the divisor) and flooring in TSA (kept in the divisor).
For AMA questions, recall the four data elements, 99.9% over one year, supervisory approval and the 20% insurance cap.
Expect conceptual questions on why gross income is a weak proxy for operational risk, and why larger banks are pushed toward more advanced approaches.
Do not confuse Basel II approaches with the Basel III standardised approach, which is the finalised version of the earlier SMA proposal. It is based on the Business Indicator Component and an Internal Loss Multiplier, and it replaced all three Basel II approaches, including the AMA.

Practice questions from Capital Regulation Before the Global Financial Crisis

Basel II Operational Risk Capital Approaches in other exams

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

Basel II Operational Risk Capital Approaches: frequently asked questions

What is the basic indicator approach formula in Basel II?

Capital equals 15% of the average annual positive gross income over the previous three years. Years with zero or negative gross income are left out of both the sum and the count of years.

What is the difference between the basic indicator, standardized and advanced measurement approaches?

BIA applies one 15% factor to total gross income. TSA splits gross income into eight business lines with betas of 12%, 15% or 18%. AMA uses the bank's own internal model at a 99.9% one-year confidence level and needs supervisory approval.

What four elements must an AMA model include?

Internal loss data, relevant external loss data, scenario analysis, and business environment and internal control factors. The bank must combine them in a sound way, and the model needs a robust governance and validation process.

Does Basel II operational risk capital still apply?

Basel III finalization replaced the three Basel II approaches, including the AMA, with a single Basel III standardised approach. That approach is the finalised version of the earlier SMA proposal. It uses the Business Indicator Component and an Internal Loss Multiplier. FRM candidates still need Basel II because exam questions test the historical framework and its weaknesses.