European banks want to get rid of bonus caps, and are calling into question the limitation measures imposed by Brussels upon banking firms in the European Union.
This regulation to limit bankers’ share of incentive compensation was implemented in the wake of the 2008 financial crisis. With no equivalent cap applied in international financial markets, European banks are lobbying the Financial Stability Council to relax the measure, pointing to a loss of competitive edge compared to their international competitors, notably those in the US and Asia.While the number of millionaire bankers rose to 4,859 in 2017 in Europe, up 262 on the previous year, can the grievances cited by major financial institutions in defence of uncapping their bonuses really be considered genuine?
Should bankers’ bonuses be uncapped, as European financial institutions are calling for? In this article, we analyse the rules set down by European regulators and how they apply to the Union’s various banking establishments.
1) THE BONUS CAP: WHAT IS IT?
a) How the European bonus cap works
Following the financial crisis in 2008, excessive bonuses were cited as a reason for the risky financial gambles being taken by bankers, and a bonus cap was introduced. The bonus represents a portion of incentive compensation enabling bankers and other traders to maximise their individual gains. With the application of the cap, European banks feel they’re being treated unfairly and have complained about the measure to the Council for Financial Stability.
It should be noted that the European regulation is the only one of its kind. The measure sets a legal limit for bonuses at “no more than twice the fixed salary.” According to European banks, this regulation directly impedes their ability to compete with their American and Asian counterparts, who currently operate under more flexible financial regulations.
Jézabel Couppey-Soubeyran, Professor of Monetary and Financial Economics at the Sorbonne, rejects the traditional arguments put forward by the banks. “European banks are coming out with the same old rhetoric. They’re always quick to denounce any regulation that might hurt their profits.” According to the economist, for the past ten years banks have found ways to sidestep regulations, notably by increasing the share of fixed salary in their employee compensation schemes.
To do so, they have markedly increased fixed salaries, and since the legally allowed bonus is indexed to this salary, it too can be re-assessed. “Above all, it’s essential that the CFS, which has no regulatory power but does exert major influence through its recommendations and oversight activity, does not serve as the middleman for these perceived grievances,” she continues. So, are there legitimate questions to be asked about the validity of the request being made by European banks to uncap their employee bonuses?
b) The bonus: a specific mechanism of incentive compensation
In the banking industry, bonuses are awarded on an exceptional an occasional basis. They are not dependent on the achievement of specific objectives, and are at the employer’s discretion. The amounts paid out are variable, and are unilaterally set by the employer.
Their allocation is regulated by a ruling made by the Court of Cassation on 10 October 2012, which states that the employment contract may provide incentive compensation in the form of a bonus on the condition that this applies to all employees working in comparable roles. In the banking sector, the bonuses paid to investment bankers and traders are directly influenced by the risks they take on the market. Indeed, the very essence of their job is usually to speculate on the value of share prices or exchange rates.
2) WHY DID THE EUROPEAN UNION DECIDE TO CAP BANKERS’ BONUSES?
a) A cap that mostly affects the UK and France
Regulating bankers’ bonuses is the result of Brussels’ firm intention to mitigate the risks taken by bankers, which are deemed to be too often excessive. By capping bonuses at twice the employee’s fixed salary, the European Union has made a political choice which, according to certain experts, could have the opposite effect to its intended purpose - especially if the profitability objectives set by bankers and other traders remain unchanged.
According to the calculations of the European Banking Authority, the cap will primarily affect two countries in particular: the UK and France. The UK is home to many of Europe’s highest-paid bankers, while French banks tend to offer fixed salaries on the lower end of the scale, which means they have some of the highest rates of incentive compensation proportional to fixed salary anywhere in Europe.
b) The desire to protect consumer interests
By limiting the behaviour of the financial institutions deemed to have the most “kamikaze” approach, Brussels is looking to protect the interests of customers. Indeed, in order to earn more, certain bankers and traders may be encouraged to take major risks, even if this means going against the interest of their customers. The idea that “the more you risk, the more you return” has been criticized by Brussels, which is determined to protect the banking system from its past mistakes, but also to avoid a situation in which European taxpayers have to foot the bill for a future financial crisis.
In addition to capping bankers’ bonuses, the European Commission has implemented a measure requiring that a portion of the bonus paid should be deferred over time. These deferred or recoverable (“claw back”) bonuses are conditional upon long-term performance criteria.
The objective is to limit certain risk-taking by introducing a factor encouraging sustainability in the operations being planned.
On the contrary, if long-term performance levels are not achieved, a recovery (clawback) clause may be applied and the bonus may be reduced or reclaimed (fully or partially) by the employer.
c) Traders: shifting to a compensation model based on the bill of specifications rather than the final result
The goal of this approach is to limit unscrupulous behaviour by certain parties, who may deliberately opt to expose themselves to reckless risks with the sole aim of earning a higher bonus. Bankers or traders will be evaluated directly on their practices and adherence to rules laid down within a precise bill of specifications. No longer being evaluated on the nature of their final results, they will therefore be less likely to bend the rules and encouraged to respect a certain code of conduct.
3) WHY SHOULD EUROPEAN BANKERS’ BONUSES BE UNCAPPED?
a) Taking on international competitors
According to the European Banking Authority, despite being vocal critics of the double-salary bonus cap, European Banks are far from actually hitting this threshold. In 2017, not a single bank hit the legal limit imposed by Brussels. The average rate paid out by banks was 1.4x fixed salary, with France and the UK giving out bonuses in the region of 1.6x the fixed salary, which is still a fair way off the maximum limit of 2x. Elsewhere, in Germany - as in the majority of other European countries - bankers’ bonuses did not even exceed 1x their fixed salary.
How can this be the case? European banks have been obliged to increase the base level of fixed income for their employees, in order to be certain that their compensation levels won’t surpass the variable pay threshold set by Brussels. This strategy has had a direct impact on fixed costs vis-a-vis the payment of basic salaries by banks. Unlike their international counterparts, European banks seeking to continue paying their employees handsome bonuses must now contend with a significant increase in fixed costs.
b) Bonus caps and ethical conundrums
The cap also raises certain ethical questions. To a certain extent, the cap may have the opposite effect to the one intended by the regulator, encouraging bankers to take even more risks. Banking executives are opposed to this system, with little consideration for the measure’s symbolic importance. This means that incentives to find workarounds come down from above, of which one clear sign is the use of “position allowances”.
In addition, bankers who feel that their talents are being curbed by this new regulation won’t hesitate to leave investment banks en masse to head over to "hedge funds”, which are by nature subject to much fewer regulations.
