Skip to content

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

Basel III Standardised Approach for Operational Risk (SMA)

Updated 11 October 2026 · Fact-checked

The Basel III standardised approach for operational risk replaces the basic indicator, earlier standardised and advanced measurement approaches. Capital = Business Indicator Component (BIC) × Internal Loss Multiplier (ILM). BIC rises with bank size through three marginal coefficients. ILM adjusts it up or down using the bank's own ten-year loss history.

Understand Operational Risk: Standardised Approach (SMA)

Before Basel III finalisation, banks could pick from three operational risk methods: the basic indicator approach, the standardised approach and the advanced measurement approach (AMA). AMA let banks use internal models. The results varied widely between banks, so capital was hard to compare. Basel III scrapped all three and put one method in their place, the standardised approach (SMA).

The SMA has two building blocks. The first is the Business Indicator (BI), an accounting-based measure of the bank's size and business volume. It is built from three parts: the interest, leases and dividend component (ILDC), the services component (SC) and the financial component (FC). You average each over three years. The BI is then turned into the Business Indicator Component (BIC) using marginal coefficients that rise with size: 12%, 15% and 18%.

The second block is the Internal Loss Multiplier (ILM). It compares the bank's own historical losses with its BIC. The Loss Component (LC) is 15 times the bank's average annual operational losses over the previous ten years. If LC equals BIC, the ILM is exactly 1. If past losses are heavier than the BIC implies, ILM is above 1 and capital rises. If they are lighter, ILM is below 1 and capital falls.

Operational risk capital = BIC × ILM. Risk-weighted assets = 12.5 × capital. For banks in the smallest bucket (BI up to €1 billion), the ILM is set to 1, so capital is just 12% of BI. National supervisors can also choose to set ILM to 1 for all banks in their jurisdiction. Banks must still collect loss data in both cases.

Why it matters for the exam: the SMA is standardised, so you can calculate it with a calculator. It is also sensitive to a bank's own loss history, unlike the older size-only approaches. Questions test the formula, the buckets and the logic of the ILM.

Key formulas to remember

Business Indicator (BI)
BI = ILDC + SC + FC (each a three-year average)
BI is measured in euros in the Basel text. It is an average of the last three years, not a single year.
Interest, leases and dividend component
ILDC = min[ |Interest income − Interest expense| , 2.25% × Interest-earning assets ] + Dividend income
The 2.25% cap limits the net interest part. Dividend income is added after the cap.
Services component
SC = max(Other operating income, Other operating expense) + max(Fee income, Fee expense)
Take the larger of each pair. Income and expense do not net off.
Financial component
FC = |Net P&L trading book| + |Net P&L banking book|
Use absolute values. A trading loss still adds to BI.
BIC, bucket 1
BI ≤ €1bn: BIC = 12% × BI
ILM is set to 1 for banks in this bucket.
BIC, bucket 2
€1bn < BI ≤ €30bn: BIC = €120m + 15% × (BI − €1bn)
The €120m is 12% of the first €1bn. Marginal rates apply only to the slice above each threshold.
BIC, bucket 3
BI > €30bn: BIC = €4,470m + 18% × (BI − €30bn)
€4,470m = €120m + 15% × €29bn.
Loss Component
LC = 15 × average annual operational losses over the previous 10 years
Losses are those above the data thresholds the bank applies.
Internal Loss Multiplier
ILM = ln[ e − 1 + (LC ÷ BIC)^0.8 ]
e ≈ 2.71828, so e − 1 ≈ 1.71828. If LC = BIC, ILM = 1.
Operational risk capital and RWA
Capital = BIC × ILM; RWA = 12.5 × Capital
The 12.5 is the reciprocal of the 8% minimum capital ratio.

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

Use this order for any SMA calculation or conceptual question.

  1. 1Identify what is given: BI components, a ready BI figure, or BIC. Check that figures are three-year averages and in the same currency unit.
  2. 2Compute ILDC: take the lower of the absolute net interest margin and 2.25% of interest-earning assets, then add dividend income.
  3. 3Compute SC and FC: take the larger of each income and expense pair for SC, and add absolute trading and banking book P&L for FC. Add all three to get BI.
  4. 4Find the bucket from BI, then compute BIC with marginal coefficients, not by applying one rate to the whole BI.
  5. 5Compute LC as 15 × average annual loss over ten years. Then compute LC ÷ BIC.
  6. 6Compute ILM = ln(e − 1 + (LC ÷ BIC)^0.8). If bucket 1 or the supervisor sets ILM to 1, skip this step.
  7. 7Capital = BIC × ILM. Multiply by 12.5 if the question asks for RWA.
  8. 8Sanity check: if LC > BIC, ILM should be above 1. If LC < BIC, it should be below 1.

Quickest way: Shortcut: check ILM direction first

When to use it: Use when options are numeric and you are short of time, or when the question only asks whether capital goes up or down.

  1. Compare LC with BIC. If LC = BIC, ILM = 1 and capital = BIC.
  2. If LC > BIC, ILM > 1, so capital is above BIC. If LC < BIC, capital is below BIC.
  3. Compute BIC first. It is often enough to eliminate two or three options.
  4. For bucket 2, remember BIC = 120 + 0.15 × (BI − 1,000) in € millions. For bucket 3, BIC = 4,470 + 0.18 × (BI − 30,000).
  5. Only run the logarithm if two options remain close.

Common mistakes in Operational Risk: Standardised Approach (SMA)

  • Applying a single rate to the whole BI, for example 15% × BI for a €5bn bank.

    Students forget the coefficients are marginal, like tax slabs.

    Fix: Apply 12% to the first €1bn, 15% to the next slice up to €30bn, and 18% above that. Use the €120m and €4,470m anchors.

  • Netting income and expense in the services component, or using the net figure instead of the larger one.

    Accounting habit of taking income minus expense.

    Fix: Take max(other operating income, other operating expense) plus max(fee income, fee expense). No netting.

  • Treating trading book losses as negative in the financial component.

    Students keep the sign of the P&L.

    Fix: Use absolute values of net trading book P&L and net banking book P&L, then add them.

  • Forgetting the 2.25% cap on interest-earning assets in ILDC.

    Students stop once they have the net interest margin.

    Fix: Always compute both and take the lower. Then add dividend income.

  • Computing LC as the average annual loss, not 15 times it.

    The factor of 15 is easy to drop from memory.

    Fix: Write LC = 15 × ten-year average annual loss. Then compare it with BIC.

  • Confusing the SMA with AMA, saying SMA still allows internal models.

    Both use internal loss data, so they sound alike.

    Fix: The SMA is a fixed formula. Internal loss data only feeds the ILM. The AMA, basic indicator and earlier standardised approaches are withdrawn.

Worked examples

Example 1

A bank has a three-year average BI of €5,000 million. Its average annual operational loss over the last ten years is €40 million. Calculate its operational risk capital and RWA under the SMA.

Show the solution
  1. BI of €5,000m is above €1,000m and below €30,000m, so bucket 2.
  2. BIC = 120 + 15% × (5,000 − 1,000) = 120 + 600 = €720m.
  3. LC = 15 × 40 = €600m.
  4. LC ÷ BIC = 600 ÷ 720 = 0.8333.
  5. 0.8333^0.8: ln(0.8333) = −0.18232; × 0.8 = −0.14586; exp = 0.8643.
  6. ILM = ln(1.71828 + 0.8643) = ln(2.5826) ≈ 0.9488.
  7. Capital = 720 × 0.9488 ≈ €683m.
  8. RWA = 12.5 × 683 ≈ €8,540m.

Answer: Capital ≈ €683 million and RWA ≈ €8.54 billion. ILM is below 1 because past losses are lighter than BIC implies.

Example 2

In € millions, a bank reports for one year: interest income 9,000; interest expense 6,500; interest-earning assets 100,000; dividend income 200; other operating income 800; other operating expense 1,100; fee income 1,500; fee expense 900; net trading book P&L −300; net banking book P&L +150. Treat this year as the three-year average. Its LC equals its BIC. Find BI, BIC and capital.

Show the solution
  1. ILDC: |9,000 − 6,500| = 2,500. Cap = 2.25% × 100,000 = 2,250. Take the lower: 2,250. Add dividends: 2,250 + 200 = 2,450.
  2. SC: max(800, 1,100) = 1,100. max(1,500, 900) = 1,500. SC = 2,600.
  3. FC: |−300| + |150| = 450.
  4. BI = 2,450 + 2,600 + 450 = 5,500.
  5. Bucket 2. BIC = 120 + 15% × (5,500 − 1,000) = 120 + 675 = 795.
  6. LC = BIC, so ILM = ln(e − 1 + 1) = ln(e) = 1.
  7. Capital = 795 × 1 = 795.

Answer: BI = €5,500 million, BIC = €795 million, ILM = 1, capital = €795 million.

Exam tips

  • Expect a mix of calculation and concept questions. Know the formula structure cold, then practise one full BI to capital calculation.
  • If an option set has numbers, compute BIC first. Often it removes wrong choices before you touch the logarithm.
  • Remember ILM = 1 when LC = BIC, and bucket 1 banks use ILM = 1. Many conceptual questions rest on these two facts.
  • Be ready to explain why the SMA replaced AMA: comparability, simplicity and less model variation across banks.
  • Watch the units. BI buckets are in euros, so a question in USD would normally state a converted figure.

Practice questions from High-level Summary of Basel III Reforms

Operational Risk: Standardised Approach (SMA) in other exams

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

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

What replaced the AMA under Basel III?

The AMA, the basic indicator approach and the earlier standardised approaches were replaced by a single standardised approach. It multiplies the Business Indicator Component by the Internal Loss Multiplier. Banks no longer build their own operational risk capital models for regulatory capital.

How do I calculate the business indicator component?

First compute BI as ILDC + SC + FC, using three-year averages. Then apply marginal coefficients: 12% up to €1bn, 15% from €1bn to €30bn and 18% above €30bn. For a bucket 2 bank, BIC = €120m + 15% × (BI − €1bn).

What does the internal loss multiplier do?

It scales BIC up or down based on the bank's own loss history. LC is 15 times the ten-year average annual loss. ILM = ln(e − 1 + (LC ÷ BIC)^0.8). It equals 1 when LC equals BIC, rises above 1 for heavier losses and falls below 1 for lighter ones.

Do all banks use the ILM?

Banks in the smallest bucket (BI up to €1bn) have ILM set to 1. National supervisors can also set ILM to 1 for all banks in their jurisdiction. In those cases capital equals BIC, but banks must still collect loss data.