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

A risk officer is explaining why the output floor was introduced in the finalised Basel III reforms. Which statement best captures its purpose?

The output floor limits how far internal models can reduce RWA relative to standardised approaches. This curbs excessive variability, reduces model risk and improves comparability of risk-based capital ratios across banks. It is not a liquidity or leverage measure.

  1. AIt ensures banks hold a minimum level of liquid assets against stressed outflows
  2. BIt limits the capital benefit from internal models and improves comparability of risk-weighted capital ratios across banksCorrect
  3. CIt caps the leverage exposure measure at a fixed multiple of Tier 1 capital
  4. DIt requires banks to use internal models for all credit exposures

Explanation

The floor constrains model-driven RWA reductions, reducing excessive variability and supporting comparability, and it acts as a backstop to model risk. Liquidity is addressed by the LCR, and the leverage ratio is a separate non-risk-based measure. The floor does not mandate internal models.

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