The European Parliament has passed legislation imposing some of the strictest rules on incentive compensation at financial institutions in an effort to transform the bonus culture that contributed to the financial crisis and end compensation incentives for excessive risk taking. Caps will be imposed on upfront bonuses and at least one-half of any bonus must be paid in contingent capital and shares. Parliament also toughened the rules on capital reserves that banks must hold to guard against any risks from their trading activities and from their exposure to highly complex securities.
The rules will apply to foreign financial institutions, such as from Japan and the US, that are established in the EU, as well as to the foreign subsidiaries of EU financial institutions. While hedge funds as such are not covered, hedge fund managers who are investment firms as defined by the Markers in Financial Instruments Directive (MiFID). are covered by the new incentive compensation rules. However, the text makes clear that the rules should be applied proportionately to investment firms. The underlying principle is that, when the investor’s money is at risk, the compensation incentives of the investment firm should be aligned with those of the investor. Under MiFID, investment firm means any legal person whose regular occupation or business is the provision of investment services to third parties and/or the performance of professional investment activities
Upfront cash bonuses are capped at 30 percent of the total bonus for most bonuses and 20 percent for large bonuses. Between 40 and 60 percent of any bonus must be deferred for at least three years and can be recovered if investments do not perform as expected. Also, at least 50 percent of the total bonus must be paid as contingent capital and shares. Bonuses will also have to be capped as a proportion of salary.
Finally, bonus-like pensions will be covered. Exceptional pension payments must be held back in instruments such as contingent capital that link their final value to the firm’s overall strength.
The legislation amends the Capital Requirements Directive to require financial institutions to reform their remuneration and bonus practices with rules that break the link between financial reward and excessive risk-taking. The effect of Parliament’s amendments is also to ensure that those remuneration policies, first and foremost, prioritize the health and stability of the financial institution, noted UK Member Arlene McCarthy, who was Rapporteur for the legislation.
The new compensation rules are binding and national regulators are authorized to take action against financial institutions that fail to comply with the imposition of financial and non-financial penalties.
The new bonus rules apply to senior management, risk takers, controllers, and employees receiving total compensation taking them into the same bracket as senior management and risk takers. What these people have in common is that their actions have a material impact on the firm’s risk profile. Ordinary sales commissions are not covered.
Until the new European Banking Authority is established, CEBS will set EU-wide guidelines in this area. Using these guidelines, regulators will decide what a large bonus is for applying the 30 percent or 20 percent cap on up front cash bonuses. Each financial institution will set a maximum limit on bonuses that is proportional to fixed salary. Regulators will decide whether the fixed and variable components of the total compensation are properly balanced, using the guidelines.