Which risks does Pillar 1 only partly capture, and what triggers each?

Pillar 1 formulas treat exposures in a standard way, for example assuming a reasonably spread-out book and collateral that works as intended, so they can understate losses when reality differs. The exam material, following CySEC's 2012 ICAAP guidelines (Circular C026), names five risks of this kind that a CIF must assess and, where needed, cover with extra capital or controls. 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. Since 26 June 2021, the IFR has also charged Class 2 CIFs extra own funds (K-CON) on trading-book exposures above the concentration limit; see How are sovereign and public-sector exposures risk-weighted, and what are the large exposure limits?. The CRD's rules on managing residual, concentration and securitisation risk are covered in What processes must a CIF have for credit, market, liquidity, operational and leverage risk?.

A credit concentration arises from one exposure, or a cluster of similar exposures, for example to the same borrower, region, industry or other risk factor, that could cause losses large enough, relative to its earnings, capital, total assets or overall level of risk, to threaten its ability to keep its core operations going or to change its risk profile materially. Concentration risk is significant for most CIFs; it usually comes from large exposures to a few counterparties, one large transaction or reliance on a single product. Concentrations are analysed for each legal entity and for the group as a whole, because a concentration that looks small in the group figures can still threaten the subsidiary that holds it.

Residual risk arises when credit risk mitigation, such as collateral or guarantees, performs poorly or fails. Typical causes are ineffective documentation, which may make security impossible to enforce, and being unable to collect a client's payment on time, or at all. The protection existed on paper, but it did not reduce the loss as expected.

Securitisation risk is the effect on the firm's financial position if a securitisation arrangement fails, or if the values and risks transferred do not emerge as expected. A firm assessing a securitisation exposure must fully understand how creditworthy the exposures underneath the structured transaction are, what risks they carry, and any concentrations among them.

Settlement risk is the risk that, when a trade settles, the other side fails to hand over the asset or the cash it owes. It matters most when a firm transfers funds on behalf of clients: until both sides have completed, the firm can lose the asset it delivered or the cash it paid.

Foreign exchange risk means losses when exchange rates move. Because currency markets are highly liquid and volatile, the losses can be significant, so CIFs must identify, measure and manage the risk. It is not limited to proprietary positions: it also covers known profit flows in foreign currencies, transactions driven by clients, and bad-debt provisions in foreign currencies.