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FRM Part II · FRM Exam Part II

High-level Summary of Basel III Reforms for FRM Part II

The Basel III reforms finalised in 2017 make bank capital more comparable and less reliant on internal models. They revise the standardised approach for credit risk, restrict IRB, add a 72.5% output floor, replace operational risk models with the SMA, overhaul CVA risk, and tighten the leverage ratio. Learn each change, its number and its purpose.

What this chapter covers

This chapter is a map of the post-crisis reforms the Basel Committee finalised in December 2017, often called Basel III finalisation. The core problem was variation in risk-weighted assets (RWA). Two banks with similar portfolios could report very different capital needs because of internal models. The reforms respond in three ways: make the standardised approaches more risk-sensitive, limit where internal models may be used, and set a floor so model-based capital cannot fall too far below standardised capital.

The chapter covers six building blocks. The revised standardised approach for credit risk changes risk weights and the use of external ratings. The IRB changes restrict advanced models and add input floors, and the output floor sets total RWA at no less than 72.5% of RWA from the standardised approaches. The Standardised Measurement Approach (SMA) replaces earlier operational risk approaches. The revised CVA risk framework removes the internal model approach. The leverage ratio and the G-SIB leverage ratio buffer add a non-risk-based backstop. The G-SIB risk-weighted buffer is different: it is a risk-based capital surcharge.

This chapter links to the rest of FRM Part II. Credit risk and operational risk chapters assume you know the capital rules behind the models. Market risk and liquidity chapters use the same Basel vocabulary. Case-style questions often ask which rule applies and what the capital effect is, so you need precise terms and numbers, not just the story.

Basel capital questions reward exact recall and clear interpretation, which makes them some of the most learnable items in the exam. The same few ideas recur across topics: less model discretion, more comparability, and a floor or backstop on capital. If you know the main parameters (72.5% output floor, SMA marginal coefficients, the 3% leverage ratio minimum, the G-SIB buffer link), you can answer both direct questions and applied scenarios. The chapter also helps you in credit, operational and liquidity topics, where the same rules appear again.

High-level Summary of Basel III Reforms: topics in the order to study them

  1. 1Basel III Reforms: Objectives and OverviewStart with the aim, reducing RWA variability and restoring credibility, because every later rule is a tool for that aim.
  2. 2Revised Standardised Approach for Credit RiskThe output floor is built on standardised RWA, so you need to understand how those are calculated first.
  3. 3Internal Ratings-Based Approach Changes and Output FloorLearn the IRB restrictions and input floors, then the floor that links them back to the standardised approach.
  4. 4Operational Risk: Standardised Approach (SMA)A self-contained formula topic that is easy to practise once the credit risk logic is clear.
  5. 5Credit Valuation Adjustment (CVA) Risk FrameworkIt builds on counterparty credit risk and shows the same move away from internal models.
  6. 6Leverage Ratio Revisions and G-SIB BufferThe leverage ratio and the G-SIB leverage buffer are the non-risk-based backstop. They make sense once you know what the risk-based rules do, including the risk-based G-SIB risk-weighted surcharge, and where those rules can fail.
  7. 7Implementation Timeline and Transitional ArrangementsFinish with dates and phase-ins, which are easiest to remember once you know what is being phased in.

How to prepare High-level Summary of Basel III Reforms

Treat this chapter as a set of rules, each with a purpose, a number and an effect on capital. Study it in that three-part form.

  1. Write one line on the purpose of the reforms: reduce excess RWA variability, improve comparability and limit model risk. Link every later topic back to it.
  2. For each topic, build a small card with three entries: what changed, the key parameter, and the likely capital effect (higher, lower or more comparable).
  3. Learn the credit risk changes by theme: external ratings and due diligence, bank and corporate exposures, real estate by loan-to-value, and credit conversion factors. Do not memorise every risk weight at first.
  4. Practise the SMA calculation by hand. Compute the Business Indicator Component with its marginal coefficients, then apply the Internal Loss Multiplier, and check which size bucket the bank falls in.
  5. Compare the old and new approach for each area in a two-column list: IRB before and after, operational risk models before and after, CVA approaches before and after.
  6. Test yourself with applied questions that ask which rule applies, what the effect is and why. Review the reasoning for every miss, not just the answer.
  7. In the last week, recite the timeline and the main numbers from memory, then recheck them against your notes.

Common mistakes in High-level Summary of Basel III Reforms

  • Treating the output floor as a floor on each risk type or each portfolio.

    Fix: Remember it applies to total RWA: model-based total RWA cannot fall below 72.5% of the standardised total.

  • Saying the reforms abolish the IRB approach.

    Fix: IRB stays for many exposures. What changes is that advanced IRB is removed for certain classes, equity IRB is removed, and input floors are added.

  • Mixing up the SMA components, for example applying the marginal coefficients to the loss component.

    Fix: Business Indicator gives BIC through the 12%, 15% and 18% coefficients. Losses enter only through the Internal Loss Multiplier. Capital = BIC × ILM.

  • Confusing the leverage ratio with a risk-weighted capital ratio.

    Fix: The leverage ratio divides Tier 1 capital by an exposure measure with no risk weighting. It is a backstop to risk-based rules.

  • Stating the G-SIB leverage buffer as equal to the risk-weighted G-SIB buffer.

    Fix: The leverage buffer is 50% of the bank's G-SIB risk-weighted buffer rate. Compute the risk-weighted buffer first, then halve it.

  • Memorising dates and numbers without knowing what they apply to.

    Fix: Attach each date or number to its rule and its purpose, then test with application questions.

Last-day revision: High-level Summary of Basel III Reforms

  • The 2017 reforms aim to cut RWA variability and restore credibility in internal models.
  • Output floor: total RWA must be at least 72.5% of RWA computed using the standardised approaches.
  • The 2017 package began the output floor phase-in at 50% in 2022 and reached 72.5% in 2027. In 2020 the Committee deferred implementation by one year to 1 January 2023, with the 72.5% floor fully applying from 1 January 2028.
  • The revised standardised approach for credit risk is more risk-sensitive and reduces mechanical reliance on external ratings.
  • Real estate exposures in the standardised approach are risk-weighted by loan-to-value ratio.
  • IRB: advanced IRB is no longer allowed for large corporates (consolidated revenues above €500 million) and for banks and other financial institutions, and the equity IRB approach is removed.
  • IRB input floors limit how low model estimates can go. For example, the PD floor is 0.05% for corporate and bank exposures, with different floors for other exposure classes.
  • The final framework is formally the revised operational risk standardised approach, commonly called the SMA. It replaces the basic indicator, standardised and advanced measurement approaches for operational risk.
  • SMA capital = Business Indicator Component × Internal Loss Multiplier; marginal coefficients are 12%, 15% and 18% by BI band. For banks in the lowest bucket (BI up to €1 billion), the ILM is set to 1, so capital equals the BIC.
  • Business Indicator bands: up to €1 billion, €1 billion to €30 billion, and above €30 billion.
  • The revised CVA framework removes the internal model approach and uses SA-CVA or BA-CVA.
  • The leverage ratio (Tier 1 capital ÷ exposure measure) must be at least 3%; the G-SIB leverage buffer is 50% of the G-SIB risk-weighted buffer.

High-level Summary of Basel III Reforms practice questions

High-level Summary of Basel III Reforms in other exams

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

High-level Summary of Basel III Reforms: frequently asked questions

What is the output floor in Basel III?

It requires a bank's total RWA, calculated with internal models, to be at least 72.5% of the RWA calculated under the standardised approaches. It limits how much internal models can lower capital requirements. It was phased in gradually, starting at 50%.

How does the SMA calculate operational risk capital?

First compute the Business Indicator from interest, lease and dividend, services, and financial components. Apply the marginal coefficients of 12%, 15% and 18% by size band to get the Business Indicator Component. Then multiply by the Internal Loss Multiplier, which reflects the bank's own loss history. For banks with a Business Indicator up to €1 billion, the ILM is set to 1, so capital equals the BIC.

Do I need to memorise all the standardised credit risk weights?

Not all of them. Focus on the structure and the logic: exposure class, use of ratings, loan-to-value for real estate, and the direction of change. Learn the headline numbers your notes flag and be ready to interpret results.

Why does the leverage ratio matter if capital ratios already exist?

Risk-weighted ratios can understate risk if risk weights or models are wrong. The leverage ratio does not use risk weights, so it acts as a simple backstop. For G-SIBs, an extra leverage buffer applies on top of the minimum.

How should I use this chapter in case-style questions?

Identify the exposure or risk type, name the relevant approach and state the rule precisely. Then explain the capital effect and why the reform was made. Clear Basel terminology helps you reject options that are close but wrong.