The EU is set to cap bonuses at 200% of basic salary, but there is no evidence that this will improve risk-taking behaviour in investment banking.

What's happening?

On April 16, 2013, the European Parliament approved proposals to cap variable pay in the EU banking sector at 100% of fixed salary. With the approval of 66% of voting shareholders – or 75% if fewer than 50% of shareholders have voted – this can be raised to 200%. At least 25% of the bonus exceeding 100% of salary must then be deferred for a minimum of five years. Up to 25% of the variable pay can be discounted if paid through long-term instruments, again defined as deferred for at least five years. The discounting method and eligible instruments are to be determined by the European Banking Authority (EBA) by March 31, 2014. The cap would apply to all entities covered by Capital Requirements Directive (CRD) IV, including EU-headquartered banks and EU subsidiaries of foreign banks.

The Council of the EU must next vote on the package, and if it does so before the end of June 2013, the cap would then come into effect on January 1, 2014. It would not be applied retroactively, so the first bonus round affected would seem to be in the first quarter of 2015, for pay based on employee performance in 2014.

Who's affected?

The directive states that the cap should apply to material risk takers, not to all staff. The EBA is examining this description to provide a clearer definition, and there is a growing belief that the eventual rules will be based purely on the level of pay rather than some qualitative measure. That would greatly increase the number of staff affected.

“Non-proprietary traders could make the case that they were not risking the bank’s own money, but they can pose a reputational risk for the bank, and they would clearly be caught if the definition is based on total pay,” says Alexandra Beidas, an employee incentives lawyer at Linklaters.

What do the banks say?

There was still too much uncertainty over the final rules for banks to seek shareholder approval for the 200% cap during the March 2013 annual general meeting season. Foreign-owned subsidiaries remain unclear on whether they will need approval simply from their parent bank, or from their parent bank’s shareholders.

Perhaps the greatest concern among banks is that this will not be a 'maximum harmonisation' directive, allowing national regulators to go further than the basic rules if they choose. And banks are still in the process of implementing the bonus clawback and deferral provisions of CRD III, imposed in 2011.

“As far as they can, banks like to operate remuneration policies on a global basis, without just following the highest common denominator. The EBA may be able to provide more consistency, but there was a lot of divergence between jurisdictions over the CRD III deferral rules,” says Ms Beidas.

There have been questions about whether banks will seek to increase the fixed component of pay, which would actually weaken the link between salary and responsible risk management. However, the directive defines fixed pay as that portion applying to fulfilling the job description, and Ms Beidas says this could give regulators grounds to prevent steep basic pay inflation.

Exasperation

What do the regulators say?

The bonus cap is very much a political initiative, and there are indications that regulators do not think highly of it. The September 2012 report by the high-level EU commission under Finnish central bank governor Erkki Liikanen proposed paying bonuses in bail-inable bonds to ensure that performance-related pay was linked to downside risks, rather than trying to intervene with the quantum of discretionary pay.

“We did not propose capping income because there is little empirical research on the link between pay and risk taking, or even the reasons why pay is so high in some areas of investment banking,” says Jan Pieter Krahnen, director of the Centre for Financial Studies at Goethe and a member of the Liikanen Commission.

Can we live without it?

A resounding yes, most importantly from the shareholders who invest in the banks. A survey among its members by the Chartered Institute for Securities & Investment (CISI) found 58% of respondents were in favour of shareholders having a say on pay, but only 6% favoured government-determined pay limits for banks. CISI chief executive Simon Culhane pointed out that UK banks caught up in the Libor scandal had clawed back £600m ($911m) in deferred bonuses from employees implicated, suggesting that the existing system is starting to bite in any case. Mr Krahnen believes the weight of regulatory measures imposed on the financial sector makes the bonus cap plan redundant.

“We have such a large number of regulatory efforts going in the same direction, all of which are bringing the true sense of individual default risk back into the industry and back into funding costs. As a result, the incentives for excessive risk taking have already been inhibited,” he says. 

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