How does the Standardized Measurement Approach (SMA) calculate operational risk capital under Basel III?

The Standardized Measurement Approach (SMA) is Basel III's single method for calculating operational risk capital, replacing the previous menu of Basic Indicator, Standardized, and Advanced Measurement approaches. It combines a financial statement-based indicator with historical loss experience.

The Business Indicator (BI)

The BI captures a bank's operational risk exposure through three components derived from financial statements:

1. Interest, Lease, and Dividend Component (ILDC):

> ILDC = min(|Interest Income - Interest Expense|, 2.25% x Interest-Earning Assets) + Dividend Income

1. Services Component (SC):

> SC = max(Fee Income, Fee Expense) + max(Other Operating Income, Other Operating Expense)

1. Financial Component (FC):

> FC = |Net P&L on Trading Book| + |Net P&L on Banking Book|

> BI = ILDC + SC + FC

The BI Component (BIC)

The BI is mapped to capital through marginal coefficients that increase with bank size:

Example: Thornfield National Bank

Thornfield National has:

• ILDC = EUR 2.8B
• SC = EUR 1.5B
• FC = EUR 0.7B
• BI = EUR 5.0B

BIC calculation (marginal):

• First EUR 1B x 12% = EUR 120M
• Next EUR 4B (from 1B to 5B) x 15% = EUR 600M
• BIC = EUR 720M

Internal Loss Multiplier (ILM)

For Bucket 2 and 3 banks, SMA incorporates historical loss experience through the Loss Component (LC), which is 15 times the average annual operational risk losses over the past 10 years.

Thornfield's average annual op risk losses = EUR 180M, so LC = 15 x 180M = EUR 2.7B.

The ILM is then:

> ILM = ln(exp(1) - 1 + (LC / BIC)^0.8)

ILM = ln(exp(1) - 1 + (2700/720)^0.8) = ln(1.718 + 3.05) = ln(4.77) = 1.56

SMA Capital = BIC x ILM = EUR 720M x 1.56 = EUR 1,123M

If Thornfield had lower historical losses (say EUR 30M average), LC would be EUR 450M and ILM would be lower, reducing capital. Conversely, heavy loss histories amplify capital requirements.

FRM exam tip: Know the three BI components, the bucket structure, and the concept of ILM. Understand that SMA makes operational risk capital more loss-sensitive than the old standardized approach but less model-dependent than AMA. Questions may ask you to compute BIC given financial data or explain why the ILM creates incentives for better risk management.

Practice more Basel III questions in our FRM Part II question bank.