When compensation regulation misses the mark
On December 21, 2015 the EBA published its final "Guidelines on sound remuneration policies and disclosures" as required by the Capital Requirements Directive (CRD IV). Petra Knab-Hägele on contents and consequences.
On December 21, 2015 the European Banking Authority (EBA) published its final "Guidelines on sound remuneration policies and disclosures" as required by the Capital Requirements Directive (CRD IV). hkp.com spoke to hkp/// group expert Petra Knab-Hägele about the contents and consequences of the new regulations for compensation practice at banks and other financial service providers in the European Union.
hkp.com: What firms are affected by the EBA Guidelines?
Petra Knab-Hägele: The new guidelines will be relevant for all financial institutions covered by the CRD IV. While this does not change the scope of application as compared to the existing regulation, a much larger number of firms will have to implement the most burdensome “minimum requirements” that were originally meant only for big banks. Previous regulation still allowed for the neutralization of these minimum requirements.
So the proportionality principle, under which larger firms are subject to stricter regulation, is already history?
Petra Knab-Hägele: Not entirely. The idea of proportionality is not completely done away with but it now takes the form of increased requirements for significant financial institutions.Even small savings banks will have to identify "risk takers" – anyone who has a material impact on the institution’s risk profile. The variable remuneration of all of these individuals will then have to be subject to the minimum requirements.
How many additional firms will have to apply these minimum requirements?
Petra Knab-Hägele: It would mean a massive increase in the number of affected institutions – in Germany, from 50 to over 3,000.There would be a significant increase in Austria, too. The regulation also affects companies headquartered outside the EU, such as the EU subsidiaries and branches of Swiss or American banks, a fact that's often ignored.
What exactly do the Guidelines require apart from the identification of risk takers?
Petra Knab-Hägele: Firms will have to defer a substantial part of the variable remuneration paid to risk takers over a three to five year period. For the senior management of significant institutions the minimum deferral period is five years. And half of the variable remuneration has to be paid out in instruments, with an additional one year retention period.Previously, deferred compensation could use a pro rata vesting schedule, so risk takers would receive their bonus in equal annual portions. According to the new EBA Guidelines, pro rata vesting should be avoided where clawbacks are impossible.
For example in Austria and Germany…
Petra Knab-Hägele: Exactly. As a result, the affected individuals would receive a large proportion of their variable compensation for a particular business year only after five years have passed, with an additional one year retention period for the amounts paid in instruments.
The new regulations for variable compensation also apply to minimal amounts. Does that mean that the thresholds currently in place would no longer apply?
Petra Knab-Hägele: At the moment, the regulations in Germany and many other EU countries include a threshold below which variable compensation is not subject to the complex deferral regulations, even in significant institutions.In Germany the threshold is EUR 50,000, for example; in Austria EUR 30,000. Under the new EBA Guidelines these thresholds would cease to apply.
So what would happen with a bonus of, say, EUR 1,000?
Petra Knab-Hägele: For a bonus of EUR 1,000 awarded to an employee in a significant institution, 60% would be deferred for five years. Half of these EUR 600, plus half of the remaining EUR 400, would have to be paid in instruments, with an additional minimum retention period of one year.
Paying variable compensation in instruments – what exactly does that mean?
Petra Knab-Hägele: A minimum of 50% of variable compensation must be paid in the form of instruments. For institutions listed on the stock market, shares should be used as instruments.
What about the many financial institutions that are not listed on the stock market?
Petra Knab-Hägele: They would need to use share-linked instruments. For small institutions such as local savings banks it would be highly complex.
That sounds like a costly endeavor.
Petra Knab-Hägele: The effort involved would be both enormous and unjustified. The EBA is really using a sledgehammer to crack a nut. And remuneration systems do not get any better because of it.
Will the 1:1 ratio cap still apply, whereby the size of the variable compensation may not be greater than the size of the fixed compensation?
Petra Knab-Hägele: The 1:1 ratio cap on fixed to variable remuneration will still apply. However, in the future it will also apply to asset management firms and other non CRD IV-firms within the scope of prudential regulation.
The stricter rules on variable compensation seem excessive, to some extent out of line with the market. Do you have any explanation for this?
Petra Knab-Hägele: The experts at the EBA were bound by EU law, specifically the CRD IV Directive, when they drew up the new Guidelines. They could not ignore its requirements. However, they expressed their disapproval in a position paper published in parallel with the new Guidelines – something that is quite unprecedented.That shows that they have not lost their grip on reality. They argue in favor of retaining the exceptions for small and non-complex financial institutions, and exempting small amounts of variable compensation from the regulations. That is something we would all support.
Then why don’t firms get rid of variable compensation altogether and avoid the regulatory pressure?
Petra Knab-Hägele: Unfortunately, this would not be tolerated by the regulators. Variable remuneration for risk takers has become part of the risk management. Consequently, risk takers must receive part of their compensation in the form of variable compensation. So abandoning variable remuneration is not an option for firms.
When will the new EBA Guidelines come into force?
Petra Knab-Hägele: The new Guidelines must be implemented in national law in EU Member States by January 1, 2017. In Germany, we are expecting the new InstitutsVergV’s directive to be published in mid-2016.The process will not be a smooth one. If it is implemented on the basis of the documents in their current form, the industry faces a regulatory disaster across Europe.
Can you give us any figures? What are the costs likely to be?
Petra Knab-Hägele: We expect firms to increase their HR departments by one extra member of staff on average to deal with the new regulations. Plus there are the IT costs, legal costs, and so on. All in all we estimate additional costs for the German financial sector of approximately EUR 500 million. What is more, the banking regulations are falling increasingly wide of the mark. Variable compensation is becoming more and more unrelated to the period on which it is based, and there is no guarantee that any money will even be left at the end of the deferral period. Which makes it very hard to sell to those affected.And the changes are not achieving the regulators’ goal of better risk management and lower compensation levels, either.