Bankers bonus capping provisions
We analyse and comment on what this means

You will have seen in the reports that the Trialogue reached provisional agreement on the bonus capping provisions with the capital requirements directive (CRD) IV. We understand that there is currently no detailed draft text that sets out the proposals and that instead the agreement has been on the key features of the proposed provisions. Therefore, there are likely to be further developments over the coming days and weeks. The analysis and commentary below should therefore be viewed as provisional at this time.

As we have predicted for some time, the political environment has led to rules that are real and biting with, apparently, no wide-ranging exemptions as some in the industry had been hoping for. This is leading to a requirement for significant planning work to ensure that the rules can be complied with for the 2013 bonus round, while protecting firms' commercial interests. Implementation challenges are likely to be formidable.

We expect that in the UK these provisions will apply to all firms within the scope of CRD3 except limited licence firms. Accordingly, this note focusses on the implications for directly affected firms.

The proposal

Our understanding of the proposal is set out below.

  • There would be a cap of 1 to 1 on the ratio of variable to fixed pay enshrined within CRDIV
  • This cap could be increased to 2 to 1 subject to a shareholder vote - this will be a simple majority vote unless fewer than half of shares are voted, in which case a super-majority (probably 75%) would be required
  • The cap would apply to all Code Staff, including those outside the EU. There will, however, be a review on the impact of employees outside the EU in two years' time
  • Up to a quarter of variable pay can be delivered in a "long-term form" that benefits from a discounted valuation for the purposes of the cap
  • To benefit from discounted treatment, this portion would need to have a five year vesting period, be subject to clawback, and be delivered in shares or bail-in bonds
  • The discount factor is to be determined by the European Banking Authority (EBA), under exactly what remit remains unclear - if it is a binding technical standard then the Financial Services Authority (FSA) will have little scope for interpretation, whereas if it is guidance then there may be more leeway for the FSA to determine discount factors based on plan features

Initial comments

1. Operation of the cap

The way the valuation discount will operate within the cap is crucial to the impact the proposals have (see technical addendum below).

In particular if the limit of 25% of variable pay that can be paid in long-term form is calculated before application of the discount factor, then the maximum face value cap under any circumstances (even 0% valuation factor) is 2.67 to 1. In many ways this is the most natural interpretation of the proposals.

Alternatively, if the limit of 25% is calculated after application of the discount factor, then a valuation factor of 50% applied to long-term pay would lead to a 2.5 to 1 ratio, a valuation factor of 33% to a 3 to 1 ratio, and a valuation factor of 25% would lead to a 3.5 to 1 effective ratio.

Our understanding is that the MEPs strong political intent would be to prevent the discount factor being used as a way of substantially increasing the ratio. This implies in our view either a use of the first approach, or the second approach with a valuation factor limited to at least 33%.

But clearly this is a critical area of the EBA's work, and we understand that criteria are being drawn up to define the EBA's remit in this area.


2. Remuneration in long-term form

It appears that the focus on the remuneration that benefits from a discount is the term of deferral (five years) and the vehicle (shares or bail-in bonds - a form of convertible debt). Long-term incentives have not been considered in detail. It therefore appears that long-term incentives, despite application of performance conditions, would benefit from no further discount compared with deferred bonuses, although this could potentially be a matter for local regulatory interpretation of the rules.

If discount for performance conditions is not allowed on long-term incentives, then they would cease to be an attractive remuneration mechanism as they would make very inefficient use of the capping headroom.

If local regulators have some leeway over the calculation of the discount then it is possible that long-term incentives delivered over five years may benefit from a lower discount than deferred bonuses.


3. Application outside the EU

We understand that the rules will apply to Code Staff of EU entities outside the EU, as now. As a concession to those who were asking for an exemption for non-EU staff, a review of the implications of the rules will be undertaken in two years' time.

This will be a major concern to EU banks, particularly combined with the likely increase in Code Staff numbers that may arise from the EBA's review of material risk takers, on which a Binding Technical Standard is due by the end of the year.


4. Shareholder vote

The requirement to get a shareholder vote to increase the cap from 1 to 1 to 2 to 1 is likely to put EU headquartered banks at a significant disadvantage to, say, US banks.

Our presumption is that the rules will apply to the EU regulated entity. For a US bank this means that the US parent is the shareholder, and achieving the required resolution should be straightforward.

For an EU listed bank, obtaining the required shareholder resolution will not be straightforward for two reasons. First, politically, shareholders are unlikely to welcome being put in the invidious position of voting for an increase in bonuses. Second, there will be real practical issues with obtaining the necessary shareholder approval in time for the 2013 bonus round. Clarity on the rules is likely to come too late for an effective resolution to be put to the upcoming AGMs, but this would then require either an EGM on the bonus cap later in the year, or deferral of bonuses above the cap to be made conditional upon shareholder approval in 2014. Neither is an appealing prospect.

However, if the final text, or guidance given to national regulators, determines that the vote should be taken by the ultimate shareholders, then the process of obtaining shareholder approval would be be more complicated for foreign firms than for EU listed firms.


5. Definitions of fixed and variable pay

We understand that there is no work currently being undertaken to amend these from earlier draft text, which is unclear. Given the nature of these definitions, understanding fully what is within and outside the definition of fixed pay will be an important factor in the application of the cap.


6. Application and timing

The current FSA rule on the ratio between fixed and variable remuneration applies to all firms in proportionality levels 1 to 3 other than limited licence firms. This rule will need to be amended to reflect the new CRD4 rules, and since we do not expect the FSA to be able to relax the application of proportionality, we expect that the new rules would apply to all such firms.


7. Timing

The CRD4 text on bonus caps will come into effect from 1 January 2014 - this means that firms will need to plan on the basis that bonus caps will be in place from 1 January 2014. The FSA will be required to put it into the Handbook, following consultation, according to this timetable. Although there is still much uncertainty about the timing and impact of any explanatory rules or guidance, for the reasons set out below, we believe that firms will need to work on the assumption that bonus caps will be in operation from that date.

The EBA is being asked to work on the details of the operation of the cap. This could be prepared and issued in the form of guidelines by the end of the year without difficulty. If it is prepared in the form of regulatory technical standards, which have the force of rules but require more formal consultation processes, it is not clear whether this could be achieved by end-year. Thus will leave interpretation of the directive's rules in the hands of Member States.

As noted, we expect the rules to apply only to Code staff. The EBA is being asked by CRD4 to review the criteria for 'Identified Staff' (Code Staff in the UK), and work on this is already under way. This work will have a significant impact on the bonus cap rules - it is likely that the new criteria will lead to an increase in Code Staff numbers in most firms. The new criteria will take the form of regulatory technical standards, and again there is uncertainty about whether these could be in place by the end-year.


Technical addendum - impact of approach to calculating 25% of variable pay

The analysis below assumes that a firm has obtained approval from shareholders for an increase in the ratio to 2 to 1, and considers an individual with £1m fixed pay.

Approach 1

Under the first approach, variable pay is determined, and then a quarter of variable pay amount is valued at this discounted factor to determine whether the cap is met.

Then with a discount factor of 50%, the maximum variable pay is approximately £2.29m:

Value for purposes of cap = 75% x £2.29m x 100% + 25% x £2.29m x 50% = £2m, i.e. 2 to 1 ratio.

Note that under this approach, even if the valuation factor on deferred pay is zero, the maximum cap is 2.67 to 1, as if a £2.67m is paid:

Value for purposes of cap = 75% x £2.67m x 100% + 25% x £2.67m x 0% = £2m, i.e. 2 to 1 ratio.

Approach 2

Alternatively, the 25% may be applied after application of the valuation factor.

Again using a 50% ratio, the maximum variable pay is £2.5m, with £1.5m delivered in standard form and £1m in "long-term form" benefitting from discount

Value for purposes of cap = £1.5m x 100% + £1m x 50% = £2m, i.e. 2 to 1 ratio

Value of "long-term element" is £1m x 50% = £0.5m, i.e. 25% of the total value of variable pay.

So here the real effective cap is 2.5 to 1.

Under this approach the discount factor effects the real value of the cap without limit, with for example a valuation factor of 33% leading to a 3 to 1 cap and a valuation factor of 10% leading to an effective cap of 6.5 to 1