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This week, the UK officially scrapped the “bankers’ bonus cap” following a joint consultation by the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA)[1]. In reality, this is a cap that affects people in organisations other than just banks. The scrapping of the cap represents a divergence from the position adopted by the EU where the cap is still in effect. This divergence sparked fierce debate around the adequacy of the UK’s post-Brexit prudential framework.
In this article, we examine why the cap was brought into effect and the rationale for its removal.
Why The Cap Was Brought In: The Global Financial Crisis
The Global Financial Crisis (GFC) saw the collapse of financial institutions across several countries. In the UK, banks like HBOS, Bradford & Bingley and Northern Rock failed which left many in the UK worrying about their deposits.
A key cause of the GFC is thought to be the excessive leverage within banks[2]. In short, leverage is a way for banks to increase potential gains or losses on a position or investment beyond what is possible through an investment of its own funds[3]. Whenever a financial institution’s assets are greater than its equity base, it is effectively leveraged[4]. Before the GFC, many banks were using deposits, a type of debt on their balance sheets, to expand their loan books. They were also using other types of debt like commercial paper to assist with their loan book expansion. An example of a leveraged bank prior to the GFC is HBOS. In 2007, its shareholder equity to assets ratio was 1:35, meaning that for every £1 of equity there were £35 of assets[5]. These assets were therefore acquired using various types of debt like deposits. Perhaps the strongest example of a leveraged bank before the GFC is Northern Rock. In June 2006, Northern Rock’s shareholder equity to assets ratio was approximately 1:40 although it rocketed up to about 1:65 by December 2007[6]. This reliance on leverage made banks like Northern Rock vulnerable to any adverse change to funding conditions in the financial sector[7]. Further, many of the assets these banks were financing were risky mortgage loans. When the defaults on these mortgages eventually took place, the banks were not in a position to repay their debts. Other financial institutions were also exposed to these risky mortgages given that they bought mortgage-backed securities.
After the GFC, it was thought that the remuneration of bank executives was partly responsible for the leveraged position of banks. This is because many bank executives were paid variable remuneration in the form of annual cash bonuses or other types of remuneration like share options which were typically awarded every three years[8]. This was a short period of time to base executive performance given that banks manage long-term assets like mortgages. Further, both types of variable remuneration were dependant on executives maximising key metrics like earnings per share (EPS) or total shareholder return (TSR)[9]. To get the most variable remuneration possible, executives therefore leveraged their banks to raise EPS, TSR or other key metrics. This meant that they took on more debt to maximise returns from mortgages. The problem with the remuneration of bank executives was therefore its focus on maximising short-term gain at the expense of long-term stability.
Following the GFC, the EU put into force the Capital Requirements Directive (CRD) IV, which amongst other things required its member states to put a cap on the amount of variable remuneration that people can earn in major financial institutions like banks[10]. The UK’s FCA and PRA then put this cap into effect. At present the rule’s default position requires banks to make sure that variable remuneration is not more than 100% of fixed remuneration for their material risk takers (MRTs). In short, MRTs are people with senior managerial roles like executives although others may be classed as MRTs. This default 100% cap is not fixed as banks can, following shareholder approval, push variable remuneration up to 200% of fixed remuneration for their MRTs[11].
The UK’s Scrapping Of The Cap
Following a joint consultation by the PRA and FCA[12] the UK has scrapped the bonus cap to promote greater stability in banking[13]. Given that variable remuneration, in part, was responsible for the leveraged position of banks prior to the GFC, many are questioning whether scrapping the cap is right as it will probably result in variable remuneration constituting a greater part of total remuneration for bank executives. To carry out an analysis of whether the cap must go, it is important to look at the other regulatory measures in place. This is because the cap affects the way the other measures can work.
Clawback
The first measure to look at is known as clawback. In short, variable remuneration of MRTs must be subject to clawback[14]. This is a punitive measure that authorises banks to take back the variable remuneration they paid to their MRTs[15]. This applies where the MRT caused significant losses to the bank[16]. This encourages MRTs to think about the long-term performance of their banks. They are therefore less likely to engage in short-termism if they are at risk of losing some of their remuneration by taking excessive risks in the short-term. While this is a good function of clawback, the bonus cap reduces its effectiveness. This is because the bonus cap sets an upper cap on the amount of variable remuneration an MRT can earn meaning there is less variable remuneration to claw back if an MRT causes serious losses.
Deferral
The second regulatory measure to look at is known as deferral. This prohibits banks from paying variable remuneration to an MRT unless at least 40% of it is deferred over a specified period[17]. The default deferral period is four years although it can go up to seven years for the most senior MRTs[18]. As with clawback, the deferral measure is meant to prevent short-termism within banks. This is because it is stretching out the payment of variable remuneration over a longer period which makes the remuneration more vulnerable to adverse changes to a bank’s financial performance. This means that there is less risk of MRTs trying to artificially push up a bank’s net interest income or profit with any extreme leveraging technique. Thus, extreme leverage is now something that is less likely to occur. The bonus cap limits the effectiveness of deferral as it caps the amount of variable remuneration that can be deferred in the first place, reducing the potential risk of loss to a MRT who receives a bonus.
Risk Adjustment
The third regulatory measure is known as risk adjustment. This requires banks to make adjustments to the types of metrics that they use when calculating the variable remuneration of their MRTs. As was stated before, bank executive remuneration was typically based on metrics like TSR or EPS. Under the risk adjustment measures, banks must make sure that the calculation of variable remuneration accounts for future risks as well as costs to capital and liquidity[19]. Rather than stretch the period over which variable remuneration is paid, risk adjustment measures seek to change the formulation for the payment of variable remuneration. This means that there is less emphasis on pure metrics like EPS or TSR which played a part in pushing up leverage in banks. As with the other measures, the bonus cap limits its effectiveness because it caps the amount of remuneration that is subject to risk adjustment.
Conclusion
In light of the above, and notwithstanding the political sensitivities of this issue, there appear to be justifiable reasons for the bonus cap to be scrapped as its effect of capping variable remuneration curtails the effectiveness of clawback, deferral and risk adjustment. However, if a greater proportion of a MRT’s remuneration package is variable, and subject to reduction or non-payment based on these factors, scope for employment related disputes as to the decisions taken or payments on exit are also likely to increase.
If you would like to discuss this article, which was authored by Noah Jefferies and Nick Roberts, please contact Nick or Jonathan Kitchin in Michelmores’ Commercial and Regulatory Disputes team.
References
[1] PRA ‘CP15/22 – Remuneration: Ratio between fixed and variable components of total remuneration (‘bonus cap’) (2022)
[2] World Bank Group, ‘The Leverage Ratio: A New Binding Limit on Banks’ (2009) 1
[3] Ibid
[4] Ibid
[5] PRA & FCA, ‘The Failure of HBOS Plc (HBOS): A report by the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA) 48
[6] Hyun Song Shin, ‘Reflections on Northern Rock: The Bank Run that Heralded the Global Financial Crisis’ (2009) 23 Journal of Economic Perspectives 101, 113
[7] Ibid
[8] Longjie Lu, ‘The Regulation of Bankers’ Remuneration in the UK: A Ten-Year Retrospective Analysis (2019) Journal of Business Law 8 594, 596
[9] Ibid
[10] Directive 2013/36 of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC art 94(1)(g)
[11] Ibid
[12] PRA ‘CP15/22 – Remuneration: Ratio between fixed and variable components of total remuneration (‘bonus cap’) (2022)
[13] FCA, ‘PS23/15: Remuneration: Ratio between fixed and variable components of total remuneration’ (2022).
[14] PRA Rulebook, CRR Firms, Remuneration, 15.20
[15] Longjie Lu, ‘The Regulation of Bankers’ Remuneration in the UK: A Ten-Year Retrospective Analysis (2019) Journal of Business Law 8 594, 601
[16] PRA Rulebook, CRR Firms, Remuneration, 15.21
[17] Ibid 15.17
[18] Ibid
[19] Ibid 11.1
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