UK looking down and out on banker’s bonus cap challenge

It’s a bad start to what looks as if it could be a very challenging day for the UK government with UKIP looking likely to win the by-election in Rochester and Strood.

This morning the European Court of Justice (ECJ) Advocate General Niilo Jaaskinen issued his opinion on the UK’s challenge against the EU’s banker’s bonus cap and it does not make good reading for the UK. Jaaskinen suggested that “all the UK’s pleas should be rejected and that the Court of Justice dismiss the action”. The key points of his reasoning are:

• The legal basis of the legislation cannot be challenged since remuneration in this sector “impacts directly on the risk profile of financial institutions”, since these operate freely across the EU this can have impacts on markets across the EU.
• Jaaskinen “accepts that the determination of the level of pay is unquestionably a matter for the Member States”, but since the law is just a stipulation of the ratio and not a direct cap on pay, there is still flexibility to set pay levels.
• The delegation of power to the European Banking Authority (EBA) is “valid” since it is “merely empowered to elaborate non-binding draft measures” – i.e. create technical standards.
• There has been sufficient notice of the legislation to allow firms time to adjust to the new rules.

A fairly comprehensive rejection, but there are a few points which we believe have been overlooked or under discussed, laid out below.

• One of the UK’s main arguments is that this law will result in higher fixed pay which makes remuneration less flexible and raises fixed costs for banks, thereby undermining any attempt to improve financial stability. This issue is not addressed at all in the opinion. Furthermore, while the opinion addresses the issues of remuneration impacting risk and the fact that fixed pay can still vary it does not look at how the two can interact. It is clear that as a result of this fixed pay will increase substantially but there is no question of how this impacts stability. This may be more an economic/financial point but given the issues are discussed separately their interaction should also be examined.

• The ruling could also have interesting implications for EU jurisdiction when it comes to the rate of pay. Variable pay is very loosely defined. For example, standard overtime paid at double the hourly rate could theoretically fall under EU jurisdiction by the definition used here. This highlights the importance of this ruling as a step into an area which the EU has previously largely steered clear of and the potential precedence it creates. This could develop in many unknown ways in the future.

• There is no mention of the UK’s claim that this violates international law or is extraterritorial since it applies to all employees of EU banks no matter where they are based. We noted this may not be entirely a legal issue for the ECJ but it deserves some attention. Related to this, it remains unclear whether third countries firms operating in the EU will be forced to institute similar caps if there are to be deemed ‘equivalent’ under rules coming in under MiFID II in 2016.

• One of the weakest points seems to be on the powers transferred to the EBA. Control over technical standards, particularly here, should not be dismissed lightly. The regulation deals in very broad strokes and leaves significant interpretation for the technical rules – including the exact level of the cap and who it will apply to. This power is being borne out right now with the EBA passing judgement on the way in which the rules are being implemented and whether ‘allowances’ count as variable pay. The EBA retains significant power to judge how the rules are being implemented and adjust the technical standards if it think the spirit of the rule is not being followed.

• In general, the combination of the ECJ and EBA seem overly focused on the UK (accepted the UK has been pushing the issue as well). But looking at the legislation which Germany has passed on this issue, there are serious questions over how it has implemented the rules. Germany has exempted anyone covered by collective bargaining from all the remuneration requirements of CRD IV, including the bonus cap. This is because collective bargaining is a constitutional right in Germany and cannot be overridden. While it’s not clear how many people this applies to, the principle is concerning and it is a significant exemption. Why this does not merit examination while the use of allowances as a de facto exemption does is not clear.

What happens now?

• The full ECJ ruling will come early next year and is likely to be in line with the opinion – although the ECJ did previously ignore Jääskinen’s opinion on short selling where to leant towards siding with the UK.
• The EBA will publish updated guidelines and technical standards in the new year which will incorporate its concerns about allowances. At this point the UK will likely find itself squeezed by both the EBA and ECJ and could face punishment if it is not seen to be implementing the rules properly. The UK could of course refuse, but given the high profile nature of the issue it could escalate the situation. One option for the UK would be to point to other infringements such as the German example above.
• In terms of the bigger picture, though not a huge issue on its own, this will be another ruling which plays into the hands of those who wish to see the UK exit the EU. It also continues to add to concerns over the role of the ECJ and its ability to be an impartial arbiter, particularly on financial services – an aspect which will likely be crucial if the UK is to remain an EU member both in the short and long term.

UK takes another blow over bankers' bonus cap

EBA HQ in London

The European Banking Authority (EBA) on Wednesday released the results of its investigation into whether banks across Europe have been using ‘allowances’ to skirt the EU’s bankers’ bonus cap. This is obviously a hugely contentious issue in the UK and the fact that UK banks have been taking this approach has been well publicised and oft criticised by EU politicians. But it’s interesting to note that the EBA found 39 banks across six EU states had been using such allowances, so clearly it is an issue which extends beyond the UK’s big banks.

Nevertheless, the opinion does not bode well for the UK with the EBA concluding:

“The EBA found that in most cases institutions had topped up the fixed remuneration of their staff and had introduced discretionary ‘role based' allowances which have an impact on the limit of the ratio between variable and fixed remuneration required by the EU Capital Requirements Directive (CRD IV).”

“The report showed that most of the allowances, which were the subject of the EBA investigation, did not fulfil the conditions for being classified as fixed remuneration, namely with respect to their discretionary nature, which allows institutions to adjust or withdraw them unilaterally, without any justification.”

The report is much as expected, with the EBA making the case that the allowances are not permanent pay for a number of reasons: they are revocable with little notice, specific to the staff member not the role, often have forfeit clauses therefore not permanent and are often linked to proxies for the firms performance (such as the economic environment).

The last point in particular clearly chimes with concerns from banks that they will have less control over their costs at times of economic hardship. This is exacerbated by the point (number 37 in the report) below which is frankly just a bit strange:

"Some role-based allowances might only have been introduced to comply with the bonus cap introduced by the CRD IV while retaining some cost flexibility. Cost flexibility is of importance where the performance of the institution or a business unit is no longer considered adequate."

Surely, cost flexibility is always relevant for a business, particularly one in a very competitive environment, and not just when it is failing? We’re not quite sure what the EBA is getting at there.

What happens now?

• The opinion isn’t binding, although the EBA has said it expects national regulators to make sure that all banks are in compliance by the end of the year, however, it has no legal way to enforce this (yet).
• The EBA is currently reviewing its guidelines on the issue and will hold a public consultation before the end of the year with the new official rules being published in the first half of 2015 (at this point they will be legally binding).
• In particular, if banks want to continue using allowances they will have to be “predetermined, transparent to staff and permanent”.
• Ultimately, this throws a bit more uncertainty in the mix with banks uncertain over exactly how and when to adjust their allowances.

What does this mean for the UK?

• Clearly, this is a bit of a blow for the UK. That said, the issue has already to an extent moved out of the EBA’s hands. The UK is challenging the original proposal at the European Court of Justice. Even if this proposal fails it could challenge the updated guidelines/rules which are used to implement the cap. Banks themselves could of course choose to launch legal challenges although this looks unlikely at this stage.
• Banks will ultimately find a way to pay their staff the market rate. This will likely end up being in the form of higher base salaries, something which will make banks less flexible and push up their average costs. This could potentially harm competitiveness and possibly force banks to pass on such costs to consumers.
• The biggest concern is a broader one of precedent and where laws are really made. The bonus cap was a specific law tagged onto a much larger piece of legislation to which it is largely unrelated. This significantly aided its passage through and watered down scrutiny. Then given the technical nature of the rules a lot of the holes were filled in by the Commission and the EBA in setting the exact parameters for implementation – providing a lot of power to the two institutions. The temptation to take such an approach with complex financial regulation is obvious and circumvents the little accountability and control which member states have.

This debate surely has some way to run yet but this looks to be one battle which so far the UK is losing.

UK lines up another court challenge against EU financial regulation

Last week, the UK launched another legal challenge at the European Court of Justice (ECJ) against an unwanted piece of financial regulation – this time, the bankers' bonus cap. This comes in the wake of some favourable legal assessment from a UK point of view, on short selling and the FTT (though both those cases are  still pending), as well as a win on benchmark regulation.

The details on the exact basis for the challenge remain vague but the key points of contention seem to be:

• The CRD IV legislation transfers power to the European Banking Authority (specifically the power to regulate wages in some form). When the EBA along with other supervisors was established there were clear limits put on the powers it can have, particularly ones transferred under the single market legal base (article 114). This was also a key point in the short selling case and one that the ECJ backed the UK on. Furthermore, the use of technical standards allows a significant amount of power to the EBA officials to set the boundaries of the cap.

• The second key issue is the legal base itself, should something such as a wage cap fall under the single market legal base? Furthermore, should it even be allowed under EU treaties? This may come down to a question of to the extent to which the cap actually play a role in regulating the financial system (we would say not much).

• The next issue is related to the above. The UK claims that the law is being enacted without any significant cost benefit analysis of its impact and that it remains unfit for purpose.

• There is also an extraterritoriality point to be made potentially, given that all banks headquartered in the EU will have to apply the rules across their businesses around the world, thereby setting rules outside the EU. However, this home vs. host interpretation of regulation is not unheard of. (This obviously makes the plan flawed from a practical perspective although how strong a point it is legally is not clear).

This could prove to be another important case for the UK for a number of reasons:

• It highlights a growing trend that the UK is aware it has significant legal recourse on EU issues which it does not agree with. Using this effectively will be a big part of future EU engagement.

• As we have noted before, the EU is increasingly trying to push through a wider range of measures using single market articles. Showing the limits of this approach, as was done with the short selling ruling, will be key in defining the limits to what the eurozone in particular can push ahead with under the current treaties (though the cap isn't itself a eurozone-specific issue).

• If the UK is able to secure a victory or even an adjustment in the rules it will be significant since this is the first financial services issue which the UK has been directly out voted on – making it a key symbolic point.

Having said all that, on this one, the UK will have a tough time.

Another blow in the bank bonus debate - but there's something far more fundamental at work here

Yesterday saw the opening salvo of what is sure to become a heated debate over the new ‘technical standards’ for the EU’s banker bonus rules.

Why is this so important? Well, these rules will essentially determine how far reaching the EU's already controversial bankers' bonus cap will be. But this decision also encapsulates a range of other issues that will have a defining impact in the way Europe is governed in future - and whether there's a future for the UK in there somewhere.

With that in mind, the first draft produced yesterday to launch a period of public consultation on the standards would have been particularly worrying. The key points are:

Standard quantitative criteria: related to the level of variable or total gross remuneration in absolute or in relative terms. In this respect, staff should be identified as material risk takers if:

 (i) their total remuneration exceeds, in absolute terms,  €500,000 per year, or
 (ii) they are included in the 0.3 % of staff with the highest remuneration in the institution, or
 (iii) their remuneration bracket is equal or greater than the lowest total remuneration of senior management and other risk takers, or
 (iv) their variable remuneration exceeds €75,000 and 75% of the fixed component of remuneration.

As the numerous press reports today have highlighted, these are far more wide ranging than many expected and are likely to further raise concerns that these rules will have a substantial negative impact on the City of London (and therefore the UK economy). (For background on these concerns see here and here). There are several different things going on here:

Are the EU agencies already exceeding their mandate? As we flagged up at the time of their creation, there's a substantial risk of mission creep under the EU's three supervisory agencies - EBA, ESMA, EIOPA - due to the fluid nature of these bodies. Remember, under the ECJ court case which allowed these agencies to be established under the EU single market (via QMV and co-decision), they should be blocked from having any type of decision-making powers. But EBA's standards on remuneration comes worryingly close to legislation.

Politicisation of ‘technical standards’: Related to this, and as we also flagged up at the time, technical standards have a worrying tendency to become politicised - which clearly is the case here. This type of stuff should be decided through political negotiations and defined within the regulation. Any necessary technical background and info should be provided for and incorporated, even is this means delaying the legislation slightly.

Need for non-eurozone safeguards ASAP: Though this isn't strictly a eurozone vs non-eurozone issue, it does illustrate just how vulnerable the UK and other outs could be to eurozone caucusing in banking / financial rule-making. This is also exactly why the UK and other non-eurozone countries need to ensure that the agreement in principle for double majority at the European Banking Authority - that Open Europe first floated - are held up and pushed through.

Trade-off between "single rulebook" and control: The UK says it likes the EBA since it contributes to a single rulebook for the single market, and can, for example, contribute to stamping out protectionist implementation of banking rules in Europe. This is all true. However, it does, of course, assume that the UK itself is writing the single rulebook, which may or may not be the case.

Democratic accountability: As the Times noted today, with central banks such as the Bank of England (BoE) and the ECB taking over financial supervision they must become more transparent and accountable. In this case it is unclear what role the BoE played in drafting the rules or whether they raised the concerns pushed by the government and firms in the UK.

What next?

Again, this is only a first draft. The public consultation is open until August, after which the EBA will review the evidence and provide a new draft - so a lot of the issues we highlight below should be considered with this in mind. There will then be a vote in the EBA with the final standards needing to be submitted to the Commission (which will approve or reject them) in March. One final interesting point here is that any vote in the EBA could come close to coinciding with the introduction of any double majority rules, although there are a lot of hurdles to overcome before then.

Expect a summer of furious lobbying and behind the scenes discussions as the UK and others make a final push to water down these proposals.

Has Germany really gone off the idea of an EU treaty change?

Usually technical meetings behind closed doors in Brussels are pretty dull. However, judging by some of the reports floating around, yesterday’s meeting of the EU Committee of Permanent Representatives (COREPER) may have bucked the trend somewhat. This is the negotiation forum for member states' EU ambassadors - the key guys involved in talks over EU policy. This is where a lot of decisions, de facto, are being made.

As we noted in today’s press summary the UK was outright outvoted on the plans for capital requirements for banks (CRD IV), which entail the controversial caps on bankers' bonuses. 

However, though it was already clear that the UK had lost that particular battle, it was the talks over the EU's proposed, and in part agreed, banking union which caught our eye. EU ambassadors failed to reach agreement amid continued North-South divisions, but the reason why is interesting.

Most media failed to pick up on this, but the WSJ Real Time Brussels blog rightly notes that Germany was strongly pushing for a clearer separation between the ECB's monetary duties and supervisory responsibilities, to avoid a running conflict of interest (see here). The only way this can really happen is to give the supervisory board the final say over supervisory decisions (as opposed to now when it rests with the ECB's Governing Council). This, in turn, requires EU treaty change. The Germans wanted a clear commitment from other member states that this would happen.

According to the WSJ, Berlin also insisted on giving national parliaments (not just the European Parliament) the right to ask questions and get answers on supervisory policy, and giving states under the single supervisor along with the EP the power to remove the Vice Chairman of the supervisory body.

A couple of interesting points there. This is an incredibly fluid target but those who say that Germany has 'gone off the idea' of Treaty change - in light of David Cameron's speech where he mentioned EU treaty change as an avenue for reform - clearly haven't quite appreciated the nature of the proposals floating around. Of course, Berlin won't be shouting it from the rooftops ahead of a national elections and with the relationship with France at an all time low (well almost), but in many of the Germans demand on eurozone governance is an implicit acknowledgement that something has to change in the EU's institutional framework (see our table here of the broad proposals being discussed [p.9]).

The scope (limited or full treaty change), nature (EU treaty or inter-governmental) and timing will be discussed, but it will likely happen sooner or later.

What next on the EU bank bonus cap?

Today has been billed as the final chance for UK Chancellor George Osborne to secure a change in the proposal to limit bank bonuses across the EU.

It is true that any change to the broad political agreement (including the level of the ratio limiting bonuses) would probably need to be secured today – a move which looks unlikely. However, as we note in today's press summary, the technical discussions over the specifics will continue for some months, presenting the opportunity to water down the proposal behind the scenes. Numerous issues remain unresolved such as: whether the cap will apply to all staff or just the highest paid, whether it will apply to all banks or only larger ones and, most importantly, whether the EU will stick with the plans to apply it to subsidiaries (both EU ones located elsewhere and foreign ones located in the EU).

So there could yet be room for some improvements to the proposal. There are also two other issues which have cropped up in this discussion: the possibility of the UK invoking the Luxembourg compromise and potential legal challenges against the proposal.

What is the Luxembourg compromise?

See below for a box from p.31 of our ‘Continental Shift’ report (really a worth a read by the way to understand the context of this and related debates) which explains the premise (click to enlarge):

It has been muted that Osborne could trigger this at today’s meeting. This is a last resort and seems unlikely – besides it is not clear how effective it would be in this case, as it is only a gentleman's agreement.

Is the proposal open to legal challenges?

According to the FT, banks have been receiving legal advice and believe they may have a case based on Article 153.5 of the Lisbon Treaty, which says:

“The provisions of this Article shall not apply to pay, the right of association, the right to strike or the right to impose lock-outs.”

Article 153 is in the social policy chapter of the treaties. Currently, the legal base for the rule is as part of CRD IV, i.e. under financial regulation and looking to address financial risk taking. 

The Commission and MEPs have also dismissed claims of illegality, on the grounds that the rules do not limit total pay, but simply set a ratio on variable pay in an attempt to reduce risk taking, and it is not therefore social policy.

It looks likely that there will be some legal challenges, although from the private sector rather than the UK Government.

EU tightens the noose on bank bonuses

As we noted in today’s press summary, a tentative EU deal was struck last night on bank bonus curbs, as part of the broader agreement on CRD IV (which implements Basel III). We’ve discussed this in detail before, so we refer you to that post for the background.

The deal looks much as expected, although a couple of changes have been added:

• Bonuses should be limited at a 1:1 ratio to salary, which can rise to 2:1 with explicit shareholder approval.
• Up to a quarter of variable pay can be discounted and issued in instruments deferred for more than five years, which could increase the ratio above 2:1.
• Bonuses in the form of long term equity or debt that can be bailed in if a bank fails will also be given more favourable treatment.

Surprisingly, the deal still includes plans to force subsidiaries of foreign banks in the EU to adhere to the bonus rules and, more importantly, forcing all subsidiaries of EU banks in the rest of the world to do so. This could hamper competitiveness and, we suspect, may still be subject to changes. This is also an area where the UK might have expected to receive a concession.

What happens now then? EU finance ministers meet next week and will discuss the proposals. Significant changes seem unlikely, which could mark a loss for the UK, which has vehemently opposed the rules from the start.

The real question for the UK is whether it should try to force a formal vote on the issue at the meeting of finance ministers. This would raise the prospect of voting down the UK on a financial services issue – that this has never happened before is often cited by the EU as a counterargument against UK concerns over EU financial regulation. If the UK is outvoted it would mark a potentially significant precedent for the UK's future relations with the EU.

It should be remembered though that this is only a small part of the large CRD IV package, which has been continuously delayed due to MEPs' demands for bank bonuses to be included. The UK has managed to secure favourable treatment on the key aspect of the legislation – the ability to adjust national capital requirements for banks.

As we have suggested before, the debate on bank bonuses seems slightly tangential in terms of the wider debate over bank capital and broader financial stability (indeed there are valid question about why it has been lumped in with CRD IV at all). For all the talk of needing bank bonuses to limit risk taking and moral hazard in banks, the EU has supported and approved €1.6 trillion in state aid to banks over the course of the financial crisis. Many countries have pushed for limits to capital requirements and supported the easing of the Basel III liquidity controls. The EU, and the eurozone in particular, has also consistently argued for and supported bank bailouts and refused to countenance imposing losses on bank creditors, instead shifting the burden to taxpayers.

Trying to limit moral hazard by tackling excessive bank bonuses is all well and good, but it is a drop in the ocean when it remains clear that states and central banks will continue to bailout banks at any cost.