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.