What is the output floor under Basel III finalization, and how does the phase-in schedule work?

The output floor is arguably the single most impactful element of the Basel III finalization (sometimes called 'Basel IV'). It ensures that banks using internal models (IRB for credit risk, IMA for market risk) cannot produce capital requirements that are dramatically lower than the standardized approaches.

The Core Rule

Minimum capital = max(Internal Model Capital, Floor% x Standardized Capital)

The floor percentage ultimately reaches 72.5%. This means that regardless of how sophisticated a bank's internal models are, the resulting capital can never be less than 72.5% of what the standardized approach would require.

Phase-In Schedule

The floor phases in gradually to avoid cliff effects:

Note: Many jurisdictions have delayed implementation. The EU starts in January 2025, the US (Basel III Endgame) timeline has been subject to extensive debate and may differ.

Worked Example

Meridian National Bank computes:

• IRB credit risk RWA: $80 billion
• Market risk IMA RWA: $15 billion
• Operational risk: $12 billion
• Total internal model RWA: $107 billion

Standardized equivalents:

• SA credit risk RWA: $120 billion
• SA market risk RWA: $22 billion
• Operational risk (new SMA): $14 billion
• Total standardized RWA: $156 billion

At 72.5% floor:

Floor RWA = 72.5% x $156B = $113.1 billion

Since internal model RWA ($107B) < floor RWA ($113.1B), the bank must use $113.1B as its binding RWA.

Additional capital required (at 8% minimum):

• Internal model capital: $107B x 8% = $8.56B
• Floored capital: $113.1B x 8% = $9.05B
• Incremental capital: $490 million

Impact on Different Banks

• Large IRB banks with low-risk mortgage portfolios are most affected — their internal models produce very low risk weights that the floor will override
• Banks already on standardized approaches are unaffected — the floor only constrains internal model users
• Emerging market banks often already use standardized approaches, so the floor is not binding

Why the Floor Exists

1. Level playing field — prevents excessive divergence between banks using different approaches
2. Model risk mitigation — limits the damage from overly optimistic internal models
3. Credibility — restores trust in risk-weighted assets after multiple studies showed huge variation across banks

For more on Basel III endgame, check our FRM Part II course.