Capital Adequacy Requirements

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Know the numbers? Now learn the why.Read the Capital Adequacy and Prudential Supervision study notes: short answers, key numbers and the law behind each rule.

Which prudential rules apply to a Cypriot investment firm, and how are groups supervised?
What counts as own funds, and which capital ratios and buffers must be met?
How are sovereign and public-sector exposures risk-weighted, and what are the large exposure limits?

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Capital tiers & quality

What items make up Common Equity Tier 1 (CET1)?: Capital instruments, share premium accounts, retained earnings, accumulated other comprehensive income, other reserves and funds for general banking risk. Subordinated loans are NOT CET1 — they are Tier 2.
How do Additional Tier 1 (AT1) instruments differ from CET1 instruments?: AT1 instruments may include call options exercisable only at the issuer's sole discretion. CET1 instruments cannot be called, guaranteed or secured, and must absorb losses first.
Where does Additional Tier 1 rank in insolvency?: Counterintuitively, AT1 ranks AFTER (below) Tier 2 capital in liquidation. The 'Tier 1' label refers to going-concern loss-absorption quality, not liquidation priority.
What general credit risk adjustment may Tier 2 include under each approach?: Up to 1.25% of risk-weighted exposure amounts under the standardised approach, but only up to 0.6% under the advanced (IRB) approach.
What was the central objective of the CRD IV / Basel III capital reform?: Better quality of Common Equity Tier 1 capital — improving the loss-absorbing capacity of capital, not just the quantity, so it is genuinely available before any bailout.

Minimum ratios & buffers

What are the three minimum capital ratios under Regulation 575/2013 (CRR)?: Exam material: CET1 at least 4.5%, Tier 1 at least 6% and total capital (Tier 1 plus Tier 2) at least 8% of the total risk exposure amount, for every firm. Since 26 June 2021: these CRR ratios bind only banks and Class 1-minus CIFs (with a 3% leverage ratio since 28 June 2021); Class 2 and Class 3 CIFs hold CET1 of at least 56%, Tier 1 of at least 75% and own funds of at least 100% of their own funds requirement under the IFR.
What is the capital conservation buffer, and in what capital must it be held?: Exam material: a buffer of CET1, held on top of the minimum ratios, of up to 2.5% of the total risk exposure amount; a firm that falls short may not distribute more than its maximum distributable amount. Since 1 January 2019: exactly 2.5%. Since 5 November 2021: only banks and Class 1-minus CIFs hold it.
What is the maximum countercyclical capital buffer?: Normally 2.5%, but not a fixed cap: the designated authority (in Cyprus, the Central Bank of Cyprus) sets the rate between 0% and 2.5% of the total risk exposure amount, in steps of 0.25 percentage points, when credit growth is judged excessive, and may go higher where justified. It is held in CET1 and serves a different purpose from the conservation buffer, which is fixed at 2.5%; since 5 November 2021 both apply only to banks and Class 1-minus CIFs.
What restriction applies when a CIF breaches its capital conservation buffer?: It may not distribute more than the Maximum Distributable Amount (MDA) — capping dividends, buy-backs and discretionary variable remuneration until buffers are restored.
Which CIFs must maintain the capital conservation buffer?: Exam material: every CIF authorised to deal on own account and/or to underwrite on a firm commitment basis, whatever its size, because the macroprudential authority chose not to exempt small and medium-sized firms. Since 5 November 2021: only banks and Class 1-minus CIFs hold the buffer; Class 2 CIFs, including those that deal on own account or underwrite, are outside Law 6(I)/2015 whatever their size.

Risk weights & large exposures

What risk weights apply to the credit quality steps for central government exposures?: Step 1 = 0%, step 2 = 20%, step 3 = 50%, steps 4 and 5 = 100%, step 6 = 150% (the highest).
When does a 1,250% risk weight apply to qualifying holdings?: Exam material: to qualifying holdings in financial sector entities (and banking-related undertakings) above 15% of eligible capital, and to other qualifying holdings above 60%, taking the greater excess. In the CRR (since 1 January 2014) both limits concern undertakings outside the financial sector: a single holding above 15% of eligible capital, or all such holdings together above 60%; the greater excess is weighted at 1,250% (CySEC's choice, now for Class 1-minus CIFs) or deducted from CET1. Since 26 June 2021: IFR firms deduct the excess over 15% or 60% of own funds.
What is the large exposure limit to a single client or connected group?: Exam material: 25% of the CIF's eligible capital, after credit risk mitigation. Since 28 June 2021: 25% of Tier 1 capital under the CRR, for banks and Class 1-minus CIFs. Since 26 June 2021: Class 2 CIFs apply the IFR limit of 25% of own funds to their trading-book exposures only, with extra own funds (K-CON) for any excess.
What large exposure limit applies where the counterparty is a credit institution?: Exam material: the higher of 25% of eligible capital and €150 million, as long as exposures to the group's other members stay within 25%; where €150 million is more than 25%, the firm sets a reasonable limit of its own, never above 100%. Since 28 June 2021: the same mechanics against Tier 1 capital, for any institution or investment firm, not only credit institutions; Class 2 CIFs apply them to own funds, for trading-book exposures only.
Until when do the transitional large exposure exemptions remain fully exempt?: Exam material: until the large exposure rules take full effect, and not after 31 December 2028. Since 26 June 2021: that end date limits only the CRR's transitional exemptions, which CySEC's list (now in Directive DI97-01) grants to Class 1-minus CIFs; the IFR's exclusions and exemptions for Class 2 CIFs have no end date.

Own funds adjustments

What percentage of unrealised fair-value losses must be included in CET1 (from 1 Jan 2015)?: Exam material: 100% from 1 January 2015, and CySEC could also allow 100% of unrealised gains. These were transitional rules: the fair-value phase-in ended at the end of 2017 and a narrower filter for certain public-sector debt on 31 December 2025, so since 1 January 2026 unrealised gains and losses count in full.
How does the transitional CET1 deduction schedule for financial-sector holdings phase in?: Exam material: 40% in 2018, rising by 10 percentage points a year to 90% in 2023, for deferred tax assets and significant holdings in financial sector entities. In the CRR the 2018 to 2023 percentages applied only to deferred tax assets that rely on future profitability and existed before 1 January 2014. Since 1 January 2024: no phase-in remains, and all the exam material's transitional rules have ended.

Governance

What is the board of directors' role in risk management?: To approve and periodically review the strategies and policies for taking, managing, monitoring and mitigating risks, devoting sufficient time and ensuring adequate resources — not to run day-to-day operations.
Who sits on a significant CIF's risk committee, and what protects the head of risk?: Exam material: only non-executive members of the board of directors, with the knowledge and skills to monitor the risk strategy and appetite, in every significant CIF; the head of risk may be removed only with the board's prior approval. Since 5 November 2021: a Class 2 CIF needs the committee if its on- and off-balance-sheet assets averaged more than €100 million over four years, Class 3 CIFs need none, and the head-of-risk rule binds only banks and Class 1-minus CIFs.
May a non-significant CIF combine its risk committee with another committee?: Exam material: yes, with CySEC's permission it may combine the risk and audit committees, if the members have the knowledge and skills for both. Since 5 November 2021: this option exists only for banks and Class 1-minus CIFs; Law 165(I)/2021 has no such rule, and a Class 2 CIF below the €100 million test needs no risk committee at all.

Remuneration

When is guaranteed variable remuneration permitted?: Only exceptionally — when hiring new staff, limited to the first year of employment, and only where the CIF has a sound and strong capital base.
What is the cap on variable remuneration relative to fixed pay?: Exam material: 100% of fixed pay for each person, or up to 200% if shareholders approve by 66% of the votes where at least half the shares or ownership rights are represented, and otherwise by 75% of those represented. Since 5 November 2021: this cap binds only banks and Class 1-minus CIFs; Class 2 CIFs set their own ratio between fixed and variable pay, with no statutory cap.
What share and deferral rules apply to CIF variable remuneration?: Exam material: at least 50% in shares, share-linked or other eligible instruments, and at least 40% deferred over three to five years (60% for particularly high amounts), vesting no faster than pro rata. Since 5 November 2021: the same for Class 2 CIFs, except firms with average assets of €100 million or less over four years and staff whose variable pay is €50,000 or less and no more than a quarter of their total pay; Class 3 CIFs are outside these rules. Banks and Class 1-minus CIFs defer over four to five years (Class 1-minus CIFs since 26 June 2021).
Who composes the remuneration committee and whose pay does it specifically oversee?: Non-executive members of the board of directors. It specifically oversees the remuneration of senior risk and compliance officers, so their pay is not linked to the areas they control. Staff must also undertake not to use personal hedging that undermines risk alignment.

SREP

What is the SREP, over what horizon does it run, and what determines its intensity?: Exam material: CySEC's supervisory review and evaluation process, based on Circular C027 (2012) and the Basel II accord, setting the capital a CIF needs for present and future requirements over up to five years (C027 itself says three to five); its frequency and intensity follow the firm's nature, scale, complexity and systemic importance. Since 5 November 2021: it rests on Law 165(I)/2021 section 29, with Class 3 CIFs reviewed case by case. Since 19 June 2023: the EBA and ESMA guidelines judge business model viability over 12 months and strategy over at least three years.
What are the SREP stages, and where is the Pillar 2 requirement set?: Planning (CySEC requests the ICAAP), Review and Assessment of ICAAP, Review of Additional Information, Supervisory Measures (where Pillar 2 capital requirements are set), and SREP Validation. Communication with the CIF is continuous.
What is the outcome of the SREP, and what ongoing duty does it place on the CIF?: A capital resource requirement the CIF must maintain (may exceed Pillar 1). The CIF must inform CySEC when its capital resources fall — or are expected to fall — below the SREP-set requirements.

ICAAP

What is the ICAAP designed to ensure?: Appropriate identification and measurement of risks, an appropriate level of internal capital relative to the risk profile, and suitable risk management and internal control systems. (AML compliance is governed separately.)
Who owns the ICAAP, and how often must it be reviewed?: The board of directors and senior management initiate and design it (the board owns it). It must be reviewed at least annually, and sooner on any material change in strategy, business plan or operating environment.
Who performs the independent review of the ICAAP?: A function or person not involved in the ICAAP process — typically the internal audit function. Independence is a core ICAAP principle.
What forward-looking horizon must the ICAAP cover, and what if it is outsourced?: A 3-to-5-year capital planning horizon (base case and stressed). If part or all of the ICAAP is outsourced, responsibility remains fully with the CIF.
What does it mean for the ICAAP to be 'comprehensive'?: It must capture all material risks: Pillar 1 risks, risks not fully captured under Pillar 1, and all Pillar 2 risks. It is not a box-ticking compliance exercise but an integral part of management.
What are the ICAAP roles of the risk, finance, business and internal audit functions?: Risk management identifies risks and applies the stress tests; finance prepares budgets/capital plans; the business function provides data; internal audit independently reviews the process.

Pillar taxonomy

What are the three Pillar 1 risks?: Exam material: credit risk, market risk and operational risk, the risks for which Pillar 1 of the Basel II accord sets minimum capital; other risks are assessed under Pillar 2. Since 26 June 2021: Class 2 and Class 3 CIFs set their minimum under the IFR instead, as the highest of the fixed overheads requirement, permanent minimum capital and, for Class 2 only, K-factors; the three Pillar 1 risks still apply to banks and Class 1-minus CIFs.
Which risks are 'not fully covered' by Pillar 1?: Residual risk, concentration risk, securitisation risk, settlement risk and foreign exchange risk — a grey zone requiring additional Pillar 2 assessment.
Name the main Pillar 2 risks.: Liquidity risk, business risk, strategic risk, reputational risk, group risk, and legal/compliance risk — assessed in the ICAAP but outside the Pillar 1 formula.
What does the definition of operational risk include and exclude?: Exam material: it includes legal risk (for example fines, penalties or unenforceable contracts) and excludes strategic and reputational risk, which are Pillar 2 risks. Since 1 January 2025 (CRR3): the CRR definition also expressly includes model risk and ICT risk and defines legal risk separately; legal risk stays inside, and strategic and reputational risk stay outside.
What are the components of market risk?: Interest rate risk (incl. credit spreads), currency risk, equity risk and commodity risk, plus changes in volatilities and correlations.

Risk definitions

Define credit risk.: The risk of loss of principal or financial reward caused by a borrower's failure to repay a loan or otherwise meet a financial obligation. Assessed across credit limits, bond/counterparty exposures and loans.
Define residual risk.: The risk that credit risk mitigation techniques prove less effective than expected — for example, the delay or inability to realise timely payment from a client, or collateral that turns out illiquid or unenforceable.
Define settlement risk.: The risk that one party fails to deliver the asset or cash value at the time of settlement of a trade. Particularly important when a CIF transfers funds on behalf of clients; not fully covered by Pillar 1.
What is concentration risk, and at what levels is it analysed?: The risk from large exposures to a limited number of counterparties, a single large transaction, or one product/sector/geography. It must be analysed at both the local legal-entity level and on a consolidated basis.
Define liquidity risk.: The risk that a CIF has insufficient financial resources to meet its current and prospective obligations as they fall due, or can only secure them at excessive cost.
Distinguish reputational, strategic and group risk.: Reputational risk is adverse perception of the CIF by stakeholders; strategic risk arises from poor business decisions or failure to adapt; group risk emanates from the CIF's relationship with other group entities. All three are Pillar 2.

Leverage & disclosure

How is the leverage ratio calculated?: Exam material: the capital measure (Tier 1) divided by the total exposure measure, as a percentage; it uses exposures without risk weighting, so it catches risks that risk-weighted models may understate. Since 28 June 2021: the CRR sets a 3% minimum for banks and Class 1-minus CIFs; Class 2 and Class 3 CIFs under the IFR have no leverage ratio.
How is return on assets calculated for country-by-country reporting?: Exam material: net profit divided by the total balance sheet, reported with the six country-by-country items (names, activities and location, turnover, full-time equivalent staff, profit or loss before tax, tax on it and public subsidies received) by every CIF from 1 January 2015. Since 5 November 2021: return on assets applies only to banks and Class 1-minus CIFs; Class 2 CIFs publish the country-by-country items only if they have a branch, or a subsidiary that is a financial institution, abroad, and Class 3 CIFs not at all.

Stress testing

Distinguish sensitivity analysis, scenario analysis and reverse stress testing.: Sensitivity analysis changes one risk factor while holding others equal; scenario analysis changes several factors simultaneously to assess combined impact; reverse stress testing starts from the outcome (an unviable business model) and works back to the causes.
How often must stress tests be reviewed, and how should results be used?: At least annually and whenever the relevant factors are expected to change. Stress testing must be forward-looking and integral to both the ICAAP and the risk management framework; after implementing management actions the CIF should re-run the test to confirm improvement.

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