According to data compiled from their quarterly reports at the end of September 2013, nine of the world’s largest banks in the US and Europe had set aside a combined total of $51.4 billion for their bankers overall pay. This represents an overall decrease on the previous year of approximately five percent. (Hall, December 2013) and is indicative of a global decline in both the numbers and overall remuneration of bank employees. So what are the challenges currently facing European banks and how are these likely to impact on their counterparts in Wall Street.
The new European Landscape
Following the financial crisis of 2008, the regulatory landscape of remuneration in financial services in the EU has undergone a rapid evolution. The European focus has been towards tighter regulation and a reduction of bankers’ variable remuneration in order to steer banks away from a culture which rewards risk.
The European Capital Requirements Directive III brought about the introduction of the Financial Services Authority’s Remuneration Code in 2011, which implemented restrictions on variable remuneration for senior managers and ‘risk takers’ in banks and credit institutions. Since then, the climate of regulation has escalated still further. The European Parliament has sought to clamp down severely on bankers’ bonuses through the introduction of the Capital Requirements Directive IV (“CRD IV”), which is due to be implemented by member states by 1 January 2014.
CRD IV, apart from tightening capital and liquidity requirements for banks, introduces a cap on bankers’ bonuses of 100 per cent of annual salary. Exceptionally, bonuses of up to twice annual salary may be authorised by a 66 per cent shareholder majority, or a 75 per cent majority if less than half of the shares are voted.
CRD IV has presented something of a major challenge to the UK in particular. Figures released by the European Banking Authority (EBA) for 2012 remuneration suggest that the UK had some 2,714 bankers who earned in excess of €1m, while Germany had just 212, and France 177. It is no surprise that the UK government has opted to pursue the fairly risky strategy of siding with the wealthy banking community in mounting a legal challenge to the European Parliament’s interference with the ability of UK banks to compete for talent. The inevitable result if they lose is a greater emphasis on fixed remuneration (which is likely to increase dramatically) and a steady flow of migrating talent to Wall Street.
What does CRD IV entail?
The model adopted by investment banks has traditionally favoured variable remuneration as a reward for performance. Top bankers usually receive bonuses well in excess of their fixed salary. Banks pass on such annual bonus rewards using a mixture of discretionary and deferred bonuses (including cash and equity elements) which are based on both individual and overall financial performance. This has arguably led to the rewarding of risk and it is this which has motivated the regulatory clamp-down. However, the measures are also apparently driven by perceived public pressure; Philippe Lamberts, MEP, comments that “EU-wide curbs on the excessive bonuses paid to bankers would mean the EU is finally, if belatedly, responding to public interest and demand regarding the sometimes obscene level of bankers’ remuneration.”
For all EU based banks and US banks to the extent they operate local branch offices in the EU CRD IV bankers’ remuneration will entail the following:
• Variable pay will be capped at a ratio of 1:1 fixed to variable remuneration. The first bonuses to be affected will be those paid in 2015 in respect of performance in 2014.
• This ratio can be raised to a maximum of 2:1, if a quorum of shareholders representing 50% of shares participates in the vote and a 66% majority of them supports the measure.
(If the quorum cannot be reached, a 2:1 ratio can also be approved if it is supported by 75% of shareholders present.)
• The local regulators must be informed of recommendations to shareholders and of the result of any shareholder vote, which must not conflict with an institution’s obligations to maintain a sound capital base.
• Additional transparency and disclosure requirements have been put in place relating to the number of individuals earning more than one million EURO per year.
• Fifty per cent of variable remuneration must be in shares or other capital instruments, such as contingent convertible debt instruments, and at least forty per cent of variable remuneration must be deferred for three to five years. This deferred remuneration can benefit from a discounted valuation for the purposes of the cap, and deferrals of more than five years are incentivized by a slightly preferable discount factor.
• Long-term instruments must be capable of being ‘clawed-back’ or subject to bad-leaver or ‘malus’ provisions.
Who will be affected?
CRD IV will apply to credit institutions and investment firms operating in the EU.
The firms affected are those who operate within the scope of the Markets in Financial Instruments Directive and which are regulated by the Prudential Regulation Authority under BIPRU. It is not yet clear whether there will be an exemption for smaller institutions.
The bonus cap will apply to senior management within banks, ‘risk-takers’, staff engaged in controlled functions, and any employee receiving total remuneration that takes them into the same pay bracket as senior management and risk-takers, and whose professional activities have a material impact on the bank’s risk profile. This means the cap will apply to the following bank staff:
(i) those whose total remuneration exceeds €500,000;
(ii) those remunerated within the top 0.3 per cent of an institution;
(iii) those whose total remuneration exceeds that of the lowest member of senior management; and,
(iv) whose variable remuneration currently exceeds €75,000 and 75 per cent of their fixed remuneration.
The provisions are wide-reaching. They apply to all banking staff working within Europe regardless of where the bank is headquartered, and, in addition, to all of the staff employed by of a European bank regardless of where in the world they work.
What will this mean for institutions and their staff?
The immediate issue of concern is that EU-based financial institutions will struggle to compete for top talent in the US and Asian markets. (The European Commission has agreed to carry out an impact assessment of the extra-territorial effect in June 2016.)
In an effort to compete EU banks will have to increase their fixed salaries in line with the 1:1 ration of fixed to variable pay. One UK bank, Barclays has already indicated that it will both increase fixed salaries from some of its top earners and alongside this it plans to introduce a fixed monthly “seniority” payment which it will revise annually. This payment, although fixed, will not impact on pension or other benefit entitlements in the same way as salary.
Several other firms are likely to follow Barclays lead provided the FSA (the local regulator) approves this scheme. Moreover, firms are likely to seek shareholder approval to raise the cap to twice the fixed remuneration. Firms might even designate dividend payments to certain bankers (the cap does not currently apply to dividends) provided that the bank’s shareholders were willing to approve the scheme
What is the likely impact on US institutions?
In terms of the international framework, the regulatory restrictions on remuneration applying to European countries will from January 2014 be more onerous than those adopted by every other G20 nation. CRD IV goes further than the requirements for Financial Stability Board’s Principles for Sound Compensation Practices which was put forward in 2009. Regulation outside of Europe more directly reflects the FSB standards, with Asia having the most relaxed regulatory standards.
This means that for US institutions greater competition for talent is likely to come from Asia in future rather than from the UK. The top earning bankers will in all likelihood drift West or East as the impact of the bonus cap is felt.
An indirect effect is also likely to be an increase in fixed remuneration across the banking community as EU-based firms increase salaries of senior employees operating in world-wide markets.
Local advisers in the US and elsewhere will need to become familiar with the EU bonus provisions which will bite on European banks operating in their jurisdictions. The solutions adopted in the UK will also most likely work in the US market. Therefore, its very likely that in future employment practitioners who advise banks in the US will gain exposure to drafting and advising in relation to monthly “seniority” payments which are set at the outset of each financial year and which will operate much like fixed monthly drawings do in a partnership.
There is the potential for future litigation in relation to this issue, particularly given the need to defer bonuses for long periods and the likelihood that bonus awards will be tied into loyalty and will lapse if the employee leaves before they receive the payment. The potential for restraint of trade arguments (already ripe in the UK) is likely to become much more common in the US.
By Michael McCartney and Rebecca Johns, London office, Fasken Martineau LLP