Shaking Up Bankers’ Bonuses: New Legislation in the EU and UK

By Elizabeth Harrin (London)

“Since banks have failed to reform we are now doing the job for them,” says Arlene McCarthy, the vice chair of the European Parliament’s Economic and Monetary Affairs Committee (ECON) and the woman who has just spearheaded new rules on bankers’ bonuses. “We have a duty as legislators to respond to the public’s concerns by voting in favour of these tough reforms to end the obscene bonus culture. At a time when the government is making substantial cuts, scaling back public services and support to families and businesses, our constituents expect banks to prioritise stability and lending over their own pay and perks. The banks have had two years since the 2008 financial crisis to do this and have failed to act, so now we will do the job for them.”

Gone are the unlimited cash bonuses and exceptional pension payments; in come rules about capping bonuses to salary and distributing shares instead of cash. Bankers might not be happy, but taxpayers will appreciate the shift towards a culture of transparency and accountability that focuses on repaying public loans.

Don’t spend what you don’t have

The most surprising thing in the new legislation is the option for banks to claw back bonuses in some situations. You might be in for a whopping payout but you won’t get it all at once. The maximum amount of up front cash bankers will see on their payslips will be 30% of their bonus – and for large bonuses this is capped at just 20%.

Between 40% and 60% of any bonus must be deferred for at least three years. If things don’t go as planned and the investments don’t perform, expect the bank to claw this back and not give it to employees at all. That’s a long time to wait for a new yacht.

The new rules only apply to people like senior management and those paid to take risks, as their day-to-day activities have a material impact on the bank’s risk profile, and even when this group do get their hands on the money, it’s not going to be the ready cash that was once splashed around the City. At least 50% of the bonus must be in contingent capital and shares, which are basically instruments that link rewards to the underlying strength of the bank. Contingent capital funds are the first to be called upon in case the bank gets into difficulties.

All these changes mean that bonuses could be tied up for a long time, and even when bankers do get their hands on them, the bonus payouts are designed to support the institutions where they work instead of rewarding short-term risk taking behaviour. All good stuff.

“The tough new rules voted through parliament will be implemented in time for this year’s bonus payout,” says Sharon Bowles, chair of ECON. “It will stop high earning bankers taking home huge pay cheques regardless of their performance or profitability of their institution.” The changes come into effect in January for all bonuses paid after that date.

A warm response

The industry has responded positively to the news of the changes. “The British Bankers’ Association welcomes the progress made by the European Council,” says a statement issued by the BBA. Angela Knight, chief executive of the BBA recently said that many of the changes were already in place in the UK. “The majority of the remuneration proposals that have just been agreed in Europe were implemented in the UK last year,” she said. “In fact the UK was the only country that took these steps and so the main consequence of this European decision is that other European countries will now have to follow suit.”

Guy Sears, Director of Wholesale at the Investment Management Association, was equally upbeat: “The principle that remuneration structures should be considered as part of a firm’s risk management is unarguable,” he says. “We welcome the proportionate approach in this proposal.”

More capital required

The new legislation also covers stricter capital rules on bank trading activities. This will ensure that banks adequately cover the risks they are running on their trading activity, and have enough in reserve to bail themselves out without resorting to taking public loans. The estimate is that banks will have to hold three or four times more capital than they do at present. Banks have until the end of December 2011 to shore up their capital reserves as that’s when the provisions take effect, although there is a transition period until 2013.

There are also special measures for banks who were bailed out by taxpayers, which revolve around moderating the overall amounts paid in bonuses and encouraging bankers to prioritise supporting the economy instead of lining their pockets. What this actually looks like is a bit sketchy, but one of the new rules is that bonuses should be paid to the directors only in circumstances where this is ‘duly justified’, whatever that means. Still, it is a good sentiment, and we have to hope the new legislation has teeth.

“Two years on from the global financial crisis, these tough new rules on bonuses will transform the bonus culture and end incentives for excessive risk-taking,” says McCarthy, who drafted the proposals and negotiated with the governments of the 27 European Member States to agree the final law. “A high-risk and short-term bonus culture wrought havoc with the global economy and taxpayers paid the price. We have seen bank chiefs walk away from the ruins of their firm with a £16 million bonus pot, while taxpayers pick up the bill. These new rules will ensure this can never happen again.”