Bankers’ bonuses: EU rules could lead to recruitment problems

The European Parliament is leading the legislative reform of bankers’ bonuses. Last month, MEPs approved some of the strictest rules in the world on bankers’ bonuses.

Caps will be imposed on upfront cash bonuses and at least half of any bonus will have to be paid in contingent capital and shares. MEPs also toughened rules on the capital reserves that banks must hold to guard against any risks from their trading activities and from their exposure to highly complex securities.

Arlene McCarthy, an MEP involved in the negotiations, says: “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. A high-risk and short-term bonus culture wrought havoc with the global economy and taxpayers paid the price. Since banks have failed to reform we are now doing the job for them.”

But what impact will the proposals have? Since the financial crisis in 2008 many have been calling for greater controls over bankers’ remuneration, and for rewards to be linked to the longer-term performance of the bank. The European Parliament proposals do not seek to limit the level of bonus, but how it is paid, to ensure that the greater element is deferred and linked to the longer-term prosperity of the bank.

This means upfront cash bonuses will be capped at 30% of the total amount (or 20% in the case of particularly “large bonuses” – a term to be defined by national regulators). Between 40% and 60% of any bonus must be deferred for at least three years and can be withdrawn if investments do not perform as expected. At least 50% of the total bonus should be paid by way of “contingent capital” which would be funds to be called upon first in case of bank difficulties. The European Union is also trying to reduce what it sees as the disproportionate role played by bonuses in the finance sector, by establishing limits on bonuses in relation to salaries.

And there will be harsher treatment for “bailed out” banks, although the actual terms are not yet clear. If this is not done very carefully, it may affect competitive recruitment, with the most talented not wanting to work in these institutions, thereby delaying their long-term recovery.

The current Financial Services Authority guidelines only apply to 27 banks in London, but it is anticipated that the European proposals, due to take effect in January 2011, will apply to a much broader group of institutions. While the provisions should create a level playing field across the EU, countries outside it that provide “guidance”, as opposed to legislation, may find themselves more attractive to financial institutions, leading to a competitive advantage in recruitment.

Nor is it entirely clear yet how much flexibility European members will have when introducing the legislation – and any inconsistency will affect the balance in Europe. The true impact of these provisions will therefore be clearer when an agreed text is debated by the European Parliament (this is expected to take place in September) and when details of their implementation by national regulators are made public.

What is clear is that these measures will only work if there is a global response. There is already anecdotal evidence that some hedge funds are decamping to less restrictive jurisdictions, such as Switzerland, and this may become a more common trend over the next few months. The UK is the main centre for European hedge funds, but this may change.

In the last couple of years, many banks have responded to the banking crisis by deferring elements of bonus to link reward to the longer-term success of the company. This may mean that many aspects of the proposals will not result in a significant change to current practices. The area that will throw up controversy is the idea that bonuses can be “clawed back” if the bank subsequently underperforms – this may make recruitment difficult if more generous packages are available elsewhere.

In an increasingly global marketplace, many are less concerned about where they are based, provided the deal is right. While it is easy to understand why these proposals are being brought in, unless there is a global response, Europe could end up at a competitive disadvantage in the long term.

David Green, partner and head of the employment group, Charles Russell

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