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FRM Exam Part II · High-level Summary of Basel III Reforms

Basel III Output Floor and IRB Approach Changes

Updated 11 October 2026 · Fact-checked

Basel III limits how far internal models can cut capital. It removes advanced IRB for some exposures, adds input floors on PD, LGD and EAD, and sets an aggregate output floor. Total RWA must be at least 72.5% of RWA from the standardised approaches. You compute the floored RWA, then take the higher figure.

Understand Internal Ratings-Based Approach Changes and Output Floor

Under Basel II, banks with supervisory approval could use internal models to set risk weights. Two versions existed for credit risk. In foundation IRB (F-IRB), the bank estimates PD and the supervisor sets LGD and EAD. In advanced IRB (A-IRB), the bank estimates PD, LGD and EAD. Internal models gave very different risk weights for similar portfolios. That variability hurt trust in risk-weighted assets (RWA).

Basel III finalisation responds in three ways. First, it limits internal model use. A-IRB is removed for some exposures, mainly where modelling is hard or data is thin: exposures to large and mid-sized corporates (consolidated revenue above a set threshold) and exposures to banks and other financial institutions. For these, F-IRB or the standardised approach applies. Equity exposures must use the standardised approach. Specialised lending may still use the slotting approach where PD cannot be estimated reliably.

Second, input floors set minimum values for the parameters a bank may use in IRB models, such as PD, LGD and EAD. The floors stop models producing very low estimates. The PD floor is 0.05% for corporate and bank exposures. Floors on LGD and on the EAD conversion factors also apply, and they differ by exposure type and collateral. You do not need to memorise every figure. You must know that they are minimums on inputs.

Third, the output floor works on the final result. A bank adds up total RWA under its internal models. It also computes total RWA under the standardised approaches. Total RWA must not fall below 72.5% of the standardised figure. The floor applies in aggregate, across all risk types, not exposure by exposure. This means the floor caps how much capital benefit models can give, at 27.5% of the standardised RWA.

The two tools work at different levels. Input floors act on parameters inside each model. The output floor acts on the total. The output floor is a backstop and also makes banks' ratios easier to compare.

Key formulas to remember

Output floor (aggregate)
Floored RWA = max[ RWA(internal models) ; 72.5% × RWA(standardised approaches) ]
Applied to total RWA across credit, market and operational risk, not exposure by exposure.
Maximum capital benefit from models
Maximum reduction = 1 − 72.5% = 27.5% of standardised RWA
Models can never cut total RWA below 72.5% of the standardised total.
Impact of the floor
Add-on RWA = max[ 0 ; 72.5% × Standardised RWA − Internal-model RWA ]
The floor binds only when the add-on is positive.
Capital ratio after floor
CET1 ratio = CET1 capital ÷ Floored RWA
Use floored RWA as the denominator when the floor binds.
Input floor reminder
PD floor = 0.05% for corporate and bank exposures
Input floors are minimums on PD, LGD and EAD inputs. Floored inputs raise RWA from the model.

How to solve Internal Ratings-Based Approach Changes and Output Floor questions

Use this method for any question on IRB changes or the output floor. It works for conceptual and numerical items.

  1. 1Identify what is asked: a change to model use (A-IRB removal), an input floor, or the output floor calculation.
  2. 2For model-use questions, match the exposure to the approach. Large corporates and financial institutions lose A-IRB. Equities go to the standardised approach.
  3. 3For input floors, remember they are minimums. A model estimate below the floor is replaced by the floor value, which raises RWA.
  4. 4For the output floor, find total RWA under internal models and total RWA under the standardised approaches. Use the same scope for both.
  5. 5Multiply standardised RWA by 72.5%. This is the floor level.
  6. 6Take the higher of the floor level and the internal-model RWA. That is the floored RWA.
  7. 7If asked for the capital ratio, divide capital by floored RWA. If asked for the impact, subtract model RWA from the floor level when positive.
  8. 8Check the answer: floored RWA must be at least 72.5% of standardised RWA, and never below model RWA.

Quickest way: Compare, then take the maximum

When to use it: Use this for any numerical output floor question with two RWA totals given.

  1. Compute 0.725 × standardised RWA.
  2. Compare with the internal-model RWA.
  3. Pick the larger. If model RWA is already larger, the floor does not bind.
  4. Add-on is the difference, or zero.
  5. For ratios, divide capital by the picked RWA.

Common mistakes in Internal Ratings-Based Approach Changes and Output Floor

  • Applying the 72.5% floor to each exposure separately.

    Students link it to input floors, which work on individual parameters.

    Fix: The output floor applies to total RWA in aggregate. Compare two totals.

  • Calculating the floor as 27.5% of standardised RWA instead of 72.5%.

    The 27.5% reduction figure is easy to mix up with the floor itself.

    Fix: The floor level is 72.5%. The 27.5% is only the maximum benefit.

  • Saying Basel III removes all IRB approaches.

    Students overstate the reform.

    Fix: IRB remains. A-IRB is removed for certain exposures such as large corporates and financial institutions. F-IRB stays for these, and A-IRB remains for others, such as retail.

  • Treating input floors as caps.

    The word floor is confused with ceiling.

    Fix: Input floors are minimum values for PD, LGD and EAD inputs. They push RWA up.

  • Using the output floor ratio on the wrong denominator when asked for the capital ratio.

    Students divide by model RWA out of habit.

    Fix: If the floor binds, use floored RWA as the denominator.

Worked examples

Example 1

A bank has total RWA of USD 80 billion under its internal models and USD 120 billion under the standardised approaches. CET1 capital is USD 10 billion. Find the floored RWA and the CET1 ratio before and after the floor.

Show the solution
  1. Floor level = 72.5% × 120 = 87 billion.
  2. Compare 80 billion with 87 billion. The floor level is higher, so the floor binds.
  3. Floored RWA = 87 billion. Add-on = 87 − 80 = 7 billion.
  4. CET1 ratio before the floor = 10 ÷ 80 = 12.5%.
  5. CET1 ratio after the floor = 10 ÷ 87 = 11.49%.

Answer: Floored RWA is USD 87 billion, an add-on of USD 7 billion. CET1 ratio falls from 12.5% to about 11.5%.

Example 2

Which statement best describes the Basel III reforms to internal models? A) The output floor is applied exposure by exposure at 72.5%. B) A-IRB is removed for exposures to large corporates and financial institutions, and total RWA must be at least 72.5% of standardised RWA. C) All IRB approaches are abolished and banks must use the standardised approach. D) Input floors cap the PD, LGD and EAD that banks may estimate.

Show the solution
  1. Option A is wrong: the output floor is aggregate, not by exposure.
  2. Option C is wrong: IRB approaches remain for many exposures.
  3. Option D is wrong: input floors are minimums, not caps.
  4. Option B matches both reforms: A-IRB removal for certain exposures and the aggregate 72.5% output floor.

Answer: B

Exam tips

  • Expect a short calculation: 72.5% of standardised RWA, compare, take the higher. Do it first and quickly.
  • Watch the wording: minimum versus maximum. Input floors and the output floor are both lower limits.
  • Know which exposures lose A-IRB: large corporates and financial institutions. Equities move to the standardised approach.
  • Tell input floors from the output floor. One acts on parameters, the other on aggregate RWA.
  • In capital ratio questions, check whether the floor binds before choosing the denominator.

Practice questions from High-level Summary of Basel III Reforms

Internal Ratings-Based Approach Changes and Output Floor: frequently asked questions

What is the Basel III output floor?

It is a minimum on total RWA. Total RWA from internal models cannot be below 72.5% of RWA from the standardised approaches. It limits the capital benefit of internal models to 27.5% of the standardised RWA.

What is the difference between foundation IRB and advanced IRB?

In F-IRB the bank estimates PD, while the supervisor provides LGD and EAD inputs. In A-IRB the bank estimates PD, LGD and EAD itself. Basel III removes A-IRB for some exposures, such as large corporates and financial institutions.

How is the output floor calculated?

Compute total RWA under the standardised approaches and multiply by 72.5%. Compare with total RWA under internal models and take the higher. If the floor binds, the difference is the add-on to RWA.

What are input floors in the IRB approach?

They are minimum values for model inputs such as PD, LGD and EAD. If a bank's estimate is lower than the floor, the floor value is used. This raises RWA and limits overly low model outputs.