In 2014 the EU will limit bankers´ bonus payments. Who is it good for and who is it bad for: the sector, society, the economy…?

05/04/2013 | FxM – Evan Brock Gray

In an agreement between the EU, the European Commission and the leaders of the EU-27 (the European Council), a package of reform measures from an EU Directive has been passed to strengthen the stability of the financial sector and to adopt the requirements laid out in Basel . The so-called “Capital Requirements Directive, CDR4”, or the Directive regarding “capital requirements for the trading book and for re-securitisations, and the supervisory review of remuneration policies”, which was proposed and written by Parliament and the Council in December of 2010 (Directive 2010/76/EU), imposed regulation on systemic financial entities starting in December 2011 that they must increase their high-quality, core-capital to 8% (core tier 1) and was approved only a few weeks ago on March 20th (although it still has to be passed in the plenary session to take place the 15th-18th of April, 2013). The imposition of pay and other remuneration controls, and also a cap on bonuses is what has shaken the whole European financial industry.

Why did the EU decide to impose limits on pay and bonuses on bankers and financiers in European financial institutions? Because of the excessive risk taking by professional in the sector (that was highly rewarded) without taking into account the negative consequences of their actions for their companies, the taxpayers in their country and the global economy when their overly risky investments went so sour so many times that these systemic financial institutions needed a bailout with public money. According to the text of the Directive published in the Official Journal of the EU:
“Excessive and imprudent risk-taking in the banking sector has led to the failure of individual financial institutions and systemic problems in Member States and globally. While the causes of such risk-taking are many and complex, there is agreement by supervisors and regulatory bodies, including the G-20 and the Committee of European Banking Supervisors (CEBS), that the inappropriate remuneration structures of some financial institutions have been a contributory factor. Remuneration policies which give incentives to take risks that exceed the general level of risk tolerated by the institution can undermine sound and effective risk management and exacerbate excessive risk-taking behaviour. In order to address the potentially detrimental effect of poorly designed remuneration structures on the sound management of risk and control of risk-taking behaviour by individuals, an express obligation (should be implemented) for credit institutions and investment firms to establish and maintain, for categories of staff whose professional activities have a material impact on their risk profile, remuneration policies and practices that are consistent with effective risk management. Those categories of staff should include at least senior management, risk takers, staff engaged in control functions and any employee whose total remuneration, including discretionary pension benefit provisions, takes them into the same remuneration bracket as senior management and risk takers. Because excessive and imprudent risk-taking may undermine the financial soundness of credit institutions or investment firms and destabilise the banking system, it is important that the new obligation concerning remuneration policies and practices should be implemented in a consistent manner and should cover all aspects of remuneration including salaries, discretionary pension benefits and any similar benefits.”

That being said, is it fair, or even legal, that the EU should meddle in the payment practices of private European businesses? Well, now it is legal. But British financiers, among others, do not believe it´s fair or even good for the industry. First of all, those who are against the Directive say that the financial institutions will simply increase fixed salaries of their employees, something that is already taking place in anticipation of these rules. This can weaken the connection between performance and pay and, as a consequence, reduce the efficiency of the employees. The industry itself has tried to tighten this link by putting a “clawback” system into place over bonuses for bad behaviour, avoidable slip-ups or if the company experience economic hardships. Furthermore, with higher fixed salaries, a company´s ability to cut costs efficiently in times of need would be reduced. Also, there is a fear that the “best and brightest” would leave Europe in search of more lucrative employment since in other continents, like in North America, Asia o even parts of South America, there is better economic growth and more finance sector activity with less regulation on pay. The British conservative politician Martin Callanan of the ERC doesn´t think bonus caps will make markets safer because companies will find ways around the legislation, hiring their highest risk taking employees outside of the EU´s grasp, for example. Lastly, one can argue that bonus caps unjustly punish those financial entities and their employees who don´t exhibit overly risky behaviour and that haven´t needed to be bailed out with public funds.

How exactly is the bonus cap going to work? The law says that bonuses cannot be higher than an employee´s total fixed salary but can go up to double the fixed salary if shareholders vote in favour. If the bonus that´s paid is higher than the salary, the employee won´t be able to collect one fourth of the bonus for five years, which is an attempt to provide incentives for carrying out financial activities in the medium-long run. Moreover, a financial institution can pay up to one fourth of the bonus in shares, bonds or other non-cash payments with an additional plus for not cashing these out for five years. Lastly, even though the law is set to begin in January of 2014, these rules will not be applied to bonuses to be paid in 2014 but those to be rewarded in 2015.

In Spain private banking salaries can vary between 40,000€ and 60,000€ for those bankers with less than five years of
experience and between 90,000€ and 140,000€ for those with more than ten years of experience. The bonuses in private banking can vary a lot; between 25% and close to 60%. That means that if you have more than ten years of experience and reach your maximum annual variable salary, you´ll be earning around 220,000€ per year. This data are usually kept secret and in places like London or Switzerland, the average salary per year of top management in private banking is over five and four million euros, respectively (in Spain, according to Alphaville, they are around 3.7 million euros).

It´s clear that the financial and banking industries are some of the most competitive in terms of pay in the world. Honestly, this amount of money that these qualified professionals earn can be greater than the lifetime earnings of many people. Imposing bonus caps on risky activities and behaviours that, in a large part, took many of the western world economies, among others, into the “Great recession” and this endemic crisis is going to help strengthen the financial sector itself by establishing sustainable practices for the future. But since this law is not in place just yet, if you are a banker that likes to take unnecessary risks in order to earn an extra bonus without considering the consequences for others, please do it with your own money.