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FRM Part II · FRM Exam Part II · Basel III: Finalising Post-crisis Reforms

A risk manager reviews the effect of Basel III input floors on IRB models. Which statement best describes their purpose?

Input floors set minimum values for IRB parameters such as PD, LGD and EAD, so that optimistic model estimates cannot push capital too low. This reduces model risk and RWA variability. They do not replace validation or remove internal models.

  1. AThey replace the need for model validation by fixing parameter values
  2. BThey limit the extent to which model-estimated PD, LGD and EAD parameters can fall, reducing model risk and variability in RWAsCorrect
  3. CThey apply only to the standardised approach to reduce granularity
  4. DThey eliminate the use of internal models for retail exposures

Explanation

Input floors set minimum values for PD, LGD and EAD (credit conversion factors) used in IRB, constraining optimistic estimates that may understate risk. They address model risk and RWA variability but do not replace validation, apply to standardised approaches, or remove retail IRB.

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