What are the Pillar 1 risks, and how are credit, market and operational risk defined?

The Basel II accord has three pillars: minimum capital requirements, supervisory review, and market discipline through disclosure. Pillar 1 sets the minimum capital for three risks: credit, market and operational risk. Other risks are handled through the ICAAP and the SREP under Pillar 2. The exam material follows CySEC's 2012 ICAAP guidelines, Circular C026, which CySEC still publishes. Most CIFs have been under the IFR since 26 June 2021. Since 5 November 2021, Class 2 CIFs have assessed their internal capital and liquid assets together under section 18 of Law 165(I)/2021, and Class 3 CIFs only if CySEC asks. This does not replace the ICAAP but widens it: the joint EBA and ESMA guidelines call the whole process the ICARAP, made up of an ICAAP for capital and an ILAAP for liquidity, and CySEC's January 2022 practical guide to the IFR and IFD calls it the ICAAP and ILAAP.

For Class 2 and Class 3 CIFs the minimum is no longer built from these three risks. Since 26 June 2021 their own funds requirement has been the highest of the fixed overheads requirement, the permanent minimum capital and the K-factor requirement. The K-factors fall into three groups: risk to client (for example client money held and assets under management), risk to market (net position risk or clearing margin) and risk to firm (for example trading counterparty default and daily trading flow). Class 3 firms have no K-factor requirement. See Which prudential rules apply to a Cypriot investment firm, and how are groups supervised?.

Credit risk is the risk of losing principal or a financial return because a borrower does not repay a loan or honour another financial obligation. The interest charged on a loan reflects the risk the lender takes. A CIF must identify and measure credit risk, monitor and control it, and consider whether the Pillar 1 charge fully captures it. The areas to assess include credit limits given to clients for trading, investments in bonds and other instruments that carry counterparty credit risk, and loans to other entities.

Market risk threatens value, earnings or capital when market risk factors move. It covers movements in interest rates, real and nominal, and in credit and basis spreads; in exchange rates; in share prices and dividends; in commodity prices, precious metals included; and in volatilities or correlations. A CIF that deals on its own account is directly exposed. A CIF acting only as agent can still be exposed indirectly: if a client transaction fails to clear or settle properly, the firm may be left with the position.

Operational risk is the risk of loss caused by internal processes, people or systems that are inadequate or fail, or by external events. Legal risk falls within the definition; strategic and reputational risk fall outside it. CRR3, which has applied mainly from 1 January 2025, made the CRR definition expressly include model risk and ICT risk as well, and defines legal risk separately. Operational risk is among the most significant risks for CIFs, but the Basel charge only approximates it. A CIF should therefore also weigh the loss of key people, breaches of conduct of business rules, internal or external fraud, the effect of its controls, its tolerance for errors, and past costs such as trading errors. It should test its business continuity procedures, and senior management should be able to show that severe losses have been considered. Control weaknesses should normally be fixed with mitigants other than capital, above all by resolving the weakness itself.

For smaller CIFs, limits in control and management can be a significant risk. Proportionality means CySEC does not expect the sophistication of a large firm, but a smaller firm's overall risk profile may be higher. Such a firm should include this risk in its capital assessment where other measures cannot fix the limits in good time. Every CIF should also pay close attention to the controls that protect client assets; see How must an investment firm safeguard client money and financial instruments?.