In January of 2014, European Union rules became effective that limit a banker’s variable income to 100% of fixed income. This ratio can be increased to 2:1 with shareholder approval, which is routinely given. The purpose of the cap was to reduce excessive risk-taking in the financial services industry by limiting rewards for successful recklessness. While this was intended to be bad news for those in the financial industry, in actuality, it has been a banker’s bounty. Overall pay levels have remained relatively constant as banks have resorted to shifting previously at-risk pay into guaranteed income.
As soon as the bonus cap was introduced in 2013, the Financial Times reported that four out of five European banks admitted in a survey that they were planning to raise base pay in order to counteract the effect of the bonus cap on overall income. Despite the banks’ stated intentions to minimize the impact of the cap, the EU passed the law as it was. As expected, banks responded by revising their 2014 remuneration policies to increase fixed income in the form of a new category of pay: the ‘role-based’ allowance. Annual reports describe this allowance as a payment of cash or shares that takes into account the role and responsibility of the employee (or, if you are cynical, the size of his or her last bonus).
The impact of role-based pay on the guaranteed income of executives is pronounced. In 2014, Barclay’s CEO was paid a salary of £1.1 million in addition to a role-based allowance of £950,000. While the CEO’s maximum potential earning opportunity for 2014 did decrease slightly from 2013, his guaranteed income has almost doubled. An even larger benefit was seen by the CEO of HSBC, whose guaranteed income has more than doubled with the introduction of the bonus cap. In previous years, HSBC’s CEO was entitled to a maximum award of variable pay that was 900% of his salary. In order to get around the bonus cap in 2014, HSBC’s CEO was given an allowance of £1.7 million, which is in addition to, and significantly more than, his £1.25 million salary.
Bank remuneration committees have gone to great lengths to use phrases such as “fixed” and “not related to performance” when describing role-based pay in order to ensure that it cannot be classified as variable pay. However, in many cases, the amount can be adjusted upwards or downwards upon review (see Barclay’s 2013 Annual Report for example). This distinguishes role-based pay from an employee’s salary, which is non-revocable and subject only to increases over time.
The European Banking Authority (‘EBA’) released a report in October of 2014, stating that 39 financial institutions had introduced role-based pay. In the report, the EBA questions role-based pay’s compliance with EU law, pronouncing that in order for allowances to constitute fixed remuneration, the allowances must be permanent, non-discretionary and non-revocable. The majority of the role-based allowances paid out in 2014 were both discretionary and revocable in nature.
The next obvious step is for banks to remove the flimsy distinction between ‘role-based’ pay and salary by simply increasing salaries (which, incidentally, are also based on an employee’s role and responsibility). It is clear from reading the annual reports of financial institutions that they have absolutely no intention of significantly reducing the actual take-home pay of bankers unless faced with no alternative.
Given these consequences, the EU bonus cap seems deeply misguided as a policy designed to reduce excessive risk-taking. Bankers now have a large safety net in the form of a bigger guaranteed salary to fall back on if their risk-taking behaviour fails to produce results. They also have the potential to earn double that salary as a bonus if risk-taking behaviour pays off. It is possible that this structure actually incentivizes risk-taking (see the IMF’s Global Financial Stability Report which found no evidence that larger amounts of fixed pay decreases risk-taking and which indicates that a cap on variable pay can actually increase risky behaviour). Banks have no flexibility to reduce those large salaries during years of poor performance, adding to the cost of doing business. Due to these unintended consequences, the bonus cap should be scrapped as a perk that banks simply cannot afford.