FRM Exam Part II · Solvency, Liquidity and Other Regulation After the Global Financial Crisis

Basel III Finalisation, Output Floor and Operational Risk Capital

Updated 11 October 2026

Basel III finalisation (often called the endgame) revises the standardised approaches, restricts internal models with an output floor, and replaces all earlier operational risk methods with one standardised approach. Op risk capital = Business Indicator Component × Internal Loss Multiplier. The output floor sets total RWA at no less than 72.5% of the standardised RWA.

Understand Basel III Finalization and Operational Risk Capital

Basel III finalisation was agreed by the Basel Committee in December 2017. Its aim is to restore credibility to risk-weighted assets (RWA). Before the crisis, banks using internal models often reported much lower RWA than peers with similar portfolios. The reforms cut this variability.

There are three main levers. First, the standardised approaches were made more risk-sensitive (credit risk, CVA, and for market risk the FRTB). Second, internal model use was limited, for example with input floors in the IRB approach. Third, an output floor stops internal-model RWA from falling too far below standardised RWA.

The output floor works at the total bank level. Total RWA = the higher of (RWA from internal models) and (72.5% × RWA from standardised approaches). It is a floor on RWA, not a cap on capital ratios. It binds only for banks whose models give much lower RWA than the standardised approaches. The 2017 Basel schedule ran from 50% in 2022 to 72.5% in 2027. The Basel Committee's one-year delay moved this to 2023–2028. National timelines differ, and implementation and transitional arrangements vary by jurisdiction.

For operational risk, the Basel II methods (Basic Indicator, Standardised, and the Advanced Measurement Approach, or AMA) are replaced by the new Standardised Approach, called the SMA (Standardised Measurement Approach) during the 2016 consultation. The AMA let banks use internal models, and it produced widely varying capital for similar banks. The new approach is a single, non-model method that every bank uses.

The new approach has two parts. The Business Indicator Component (BIC) scales capital to the bank's size using the Business Indicator (BI), which is built from the interest, leasing and dividend, services, and financial items of the income statement. The Internal Loss Multiplier (ILM) adjusts for the bank's own loss history. Banks with higher past losses relative to their BIC get a higher multiplier. Bucket 1 banks (BI ≤ €1bn) have ILM = 1. The loss component applies to banks with BI above €1bn (buckets 2 and 3), and national supervisors may set ILM = 1 at their discretion. Larger BI means a higher marginal coefficient.

Key formulas to remember

Operational risk capital: Op risk capital = BIC × ILM; BIC is the Business Indicator Component. ILM is the Internal Loss Multiplier. Op risk RWA = 12.5 × capital.
BIC marginal coefficients: BI ≤ €1bn: 12% | €1bn to €30bn: 15% | above €30bn: 18%; Applied marginally, like tax bands. Bucket 1 banks (BI ≤ €1bn) have BIC = 12% × BI.
Internal Loss Multiplier: ILM = ln( exp(1) − 1 + (LC ÷ BIC)^0.8 ); LC is the Loss Component = 15 × average annual operational losses over the last 10 years. ILM = 1 when LC = BIC. Bucket 1 banks (BI ≤ €1bn) have ILM = 1. For banks with BI above €1bn the loss component applies, but national supervisors may set ILM = 1 at their discretion.
Loss Component: LC = 15 × average annual operational risk losses (10 years); Losses are net of recoveries and above the loss data threshold.
Output floor: Total RWA = max( RWA internal models ; 72.5% × RWA standardised ); Applied on total RWA at bank level. Standardised RWA includes the revised standardised approaches.
RWA from capital: RWA = 12.5 × capital requirement; 12.5 is the reciprocal of the 8% minimum ratio.

How to solve Basel III Finalization and Operational Risk Capital questions

Most questions are either a calculation (floor or op risk capital) or a conceptual choice between old and new approaches. Use this order.

1Identify what is asked: output floor RWA, BIC, ILM, op risk capital, or a concept comparison.
2For the output floor, compute 72.5% of total standardised RWA. Compare it with the internal-model RWA.
3Take the higher of the two. That is the binding RWA. Then apply the capital ratio if asked.
4For op risk, find BI and compute BIC by marginal bands (12%, 15%, 18%).
5Check the bucket. If BI ≤ €1bn, ILM = 1. Otherwise compute LC = 15 × average annual loss, then ILM from the formula.
6Multiply BIC × ILM for capital. Multiply by 12.5 for RWA.
7For concept questions, match the feature to the right approach: AMA used internal models; the new approach is standardised and uses loss data only through ILM.

Quickest way: Floor first, then bands

When to use it: Use for numeric MCQs with limited time.

For the floor: multiply standardised RWA by 0.725 and pick the larger number.
For BIC: split BI at €1bn and €30bn, apply 12%, 15%, 18% to each slice, then add.
Check ILM: if LC ÷ BIC is below 1, ILM is below 1. If above 1, ILM is above 1. This lets you eliminate wrong options fast.
Eliminate options that say AMA remains allowed or that the floor is a cap.

Common mistakes in Basel III Finalization and Operational Risk Capital

Applying 72.5% to internal-model RWA instead of standardised RWA.
The floor sounds like a haircut on the model result.
Fix: The floor is 72.5% of the standardised RWA. Compare it with the model RWA and take the higher.
Applying 15% to the whole BI when BI exceeds €1bn.
Students treat coefficients as flat rates.
Fix: Coefficients are marginal. Only the slice within each band gets that rate.
Forgetting that ILM = 1 for banks with BI ≤ €1bn.
Students compute ILM for every bank.
Fix: Check the bucket first. Bucket 1 banks skip the loss history.
Saying the new approach is model-based or that AMA is still allowed.
Mixing up AMA with the new approach because both use loss data.
Fix: All earlier methods (BIA, TSA, AMA) are replaced. Loss data enters only through the ILM.
Using annual loss instead of 15 × average annual loss in LC.
The multiplier of 15 is easy to forget.
Fix: Write LC = 15 × average annual losses before computing the ratio LC ÷ BIC.
Treating the output floor as a limit on capital held.
The word floor is read as a minimum capital amount.
Fix: It is a floor on RWA. The floor raises RWA, which is the denominator of the capital ratio, so banks with low model RWA must hold more capital for the same ratio.

Worked examples

Example 1

A bank has internal-model total RWA of USD 60bn. Its total RWA under the standardised approaches is USD 100bn. Under the 72.5% output floor, what RWA must it use, and what is the minimum total capital at an 8% ratio?

Show the solution

Floor RWA = 72.5% × 100bn = USD 72.5bn.
Compare with the model RWA of USD 60bn. The floor is higher, so it binds.
Capital = 8% × 72.5bn = USD 5.8bn.

Answer: RWA = USD 72.5bn and minimum total capital = USD 5.8bn.

Example 2

A bank has a Business Indicator of €40bn and an average annual operational loss of €0.4bn over the last 10 years. Its supervisor applies the loss component (it does not set ILM = 1). Compute its operational risk capital under the standardised approach. Use ILM = ln( e − 1 + (LC ÷ BIC)^0.8 ), with e − 1 = 1.7183.

Show the solution

BI is above €1bn, so the loss component applies. The supervisor has not set ILM = 1, so ILM must be computed.
BIC: 12% × 1bn = 0.12bn.
15% × (30 − 1)bn = 15% × 29bn = 4.35bn.
18% × (40 − 30)bn = 18% × 10bn = 1.8bn.
BIC = 0.12 + 4.35 + 1.8 = €6.27bn.
LC = 15 × 0.4 = €6.0bn.
LC ÷ BIC = 6.0 ÷ 6.27 = 0.957.
0.957^0.8 = exp(0.8 × ln 0.957) = exp(0.8 × −0.0440) = exp(−0.0352) = 0.9654.
ILM = ln(1.7183 + 0.9654) = ln(2.6837) = 0.9871.
Capital = 6.27 × 0.9871 = €6.19bn.

Answer: Operational risk capital is about €6.19bn (BIC €6.27bn, ILM about 0.987). If the supervisor had set ILM = 1, capital would equal the BIC of €6.27bn.

Exam tips

Memorise 72.5%, the three BI bands (€1bn, €30bn) and the 12/15/18% coefficients.
Expect compare-and-contrast questions: AMA is internal model, the new approach is standardised with an ILM. Pick the option that says earlier approaches are replaced.
In numeric questions, check whether ILM is below or above 1 before calculating to avoid sign errors.
Read whether the question asks for capital or RWA. RWA is 12.5 × capital.
Watch the wording: the floor is on total RWA and uses standardised RWA as the base.

Practice questions from Solvency, Liquidity and Other Regulation After the Global Financial Crisis

Basel III Finalization and Operational Risk Capital: frequently asked questions

What is the Basel III output floor in simple words?

It stops a bank's internal-model RWA from falling below 72.5% of what the standardised approaches would give. It limits the benefit of models and makes capital ratios more comparable across banks. The 2017 schedule ran from 50% in 2022 to 72.5% in 2027, and the Basel Committee's one-year delay moved it to 2023–2028. National timelines differ.

What is the difference between AMA and the new standardised approach for op risk?

The AMA let banks build their own internal models, which led to wide differences in capital. The new approach is a single standardised formula, BIC × ILM, and replaces the AMA, BIA and earlier standardised methods.

What is the Business Indicator Component?

It is the part of op risk capital based on the size of the bank's business. It applies marginal coefficients of 12%, 15% and 18% to the Business Indicator, which is built from income statement items.

Does Basel III finalisation matter for FRM Part II?

Yes. It sits in the regulation material and is tested with numeric floor and BIC questions as well as concept comparisons. Learn the formulas and the old versus new logic.