What is the Basel III output floor, and how does it constrain banks using internal models for capital calculation?

The Basel III output floor ensures that banks using internal models (IRB for credit risk, IMA for market risk) cannot report risk-weighted assets (RWA) below 72.5% of the amount calculated under standardized approaches. It addresses regulatory concern that internal models have produced excessively low capital requirements at some banks.\n\nFloor Mechanics:\n\nTotal RWA_floor = 72.5% x RWA_standardized (aggregated across all risk types)\n\nActual RWA = max(RWA_internal_models, RWA_floor)\n\nIf internal model RWA is already above the floor, no adjustment is needed. If below, the bank must hold additional capital.\n\nPhase-In Schedule (Basel Committee):\n\n| Year | Floor Level |\n|---|---|\n| 2023 | 50% |\n| 2024 | 55% |\n| 2025 | 60% |\n| 2026 | 65% |\n| 2027 | 70% |\n| 2028+ | 72.5% |\n\n(Note: jurisdictional implementation varies; EU and others have modified timelines.)\n\nWorked Example:\nAlpine National Bank reports RWA under both approaches:\n\n| Risk Category | IRB/IMA RWA | Standardized RWA |\n|---|---|---|\n| Credit risk | $68 billion | $112 billion |\n| Market risk | $9 billion | $14 billion |\n| Operational risk | $11 billion | $15 billion |\n| CVA risk | $4 billion | $6 billion |\n| Total | $92 billion | $147 billion |\n\nOutput floor (at full implementation): 72.5% x $147B = $106.575 billion\n\nAlpine's internal model RWA ($92B) is below the floor ($106.575B), so:\n\nBinding RWA = $106.575 billion\nAdditional RWA from floor: $106.575B - $92B = $14.575 billion\n\nAt a minimum CET1 ratio of 10.5% (including buffers):\nAdditional CET1 capital needed: $14.575B x 10.5% = $1.530 billion\n\nStrategic Impact:\n- Banks with historically aggressive internal models (low LGD estimates, favorable correlations) are most affected\n- Mortgage portfolios with low IRB risk weights face the largest floor adjustment in many jurisdictions\n- Some banks may abandon internal models entirely if the floor renders them non-binding (reverting to standardized saves model development costs)\n- The floor incentivizes banks to improve standardized approach risk sensitivity (ensuring accurate external ratings, proper collateral recognition)\n\nKey Exam Points:\n- The floor applies at the aggregate (total bank) level, not risk-type by risk-type\n- Jurisdictional discretion allows national regulators to modify the phase-in or add transitional caps on RWA increases\n- The floor does NOT replace internal models -- it sets a minimum. Banks still report internal model RWA and supervisors monitor both\n\nStudy Basel III finalization in our FRM Part II course.