EU variable pay regulation is hurting banks’ risk management

EU pay-cap is affecting banks’ ability to hire high-performing and compliance-savvy employees

Author: Sandra Kilhof
November 12, 2014

The Capital Requirements Directive IV, which has placed a cap on variable pay in the EU’s banking sector, is weakening many banks’ efforts to manage performance and risk through pay. Recent studies have shown that in an effort to remain competitive in attracting and retaining talented staff, large numbers of banks are increasing base salaries or using cash allowances as part of the pay mix. These allowances, however, cannot be performance-linked under the EBA’s definition of fixed compensation and this is skewing the market when it comes to retaining the best employees.

Since 2008, banks have made much progress structuring pay so that it allowed for appropriate consideration of risk-adjusted outcomes along with conduct and compliance behaviours over a multi-year timeframe. Essentially, banks have moved towards rewarding those who perform well under the current regulatory environment – thereby mitigating risk and fostering compliance.

A recent report by the financial consultancy Mercer, even said that organisations are continuously trying to strengthen the link between performance management and compensation, introducing individual risk-related factors in performance management and strengthening bonus-malus and clawback conditions.

This has resulted in more and more banks reducing or not paying deferred unvested awards when lower performance, non-compliance or misconduct occurs among employees. In 2012 alone, 62 percent of banks applied malus, with it being more prevalent among European banks compared to the US.

Interestingly, the majority of banks are reducing pay to individuals due to non-compliance or misconduct, while a far smaller portion of banks apply such malus as a reaction to poor performance. This has gone to show that banks are becoming more aware of the consequences and ensuing fines that non-compliance could lead to, rather than the costs of bad performance.

No longer rewarding performance
However, problematically the progress the banks have made in improving their pay practices over the last several years since the crisis is now being reversed to some extent with the impact of the CRD IV rules. In order to remain competitive, banks are shifting a significant portion of compensation into fixed, guaranteed pay, which reduces their ability to pay for performance and also to defer as much compensation subject to malus over a multi-year performance period. In some cases banks are even opting not to pay any upfront annual cash bonus at all, in light of the increases in fixed pay, and are shifting all variable compensation into multi-year deferral or long-term incentive arrangements.

The pay-cap puts increasing stress on banks to hike salaries on an overall basis in order to retain their staff and meet current industry remuneration standards

High-performing employees expect a salary comparable to their peers, but CRD IV restricts EU-headquartered banks in what they can pay in performance-related compensation. This has prompted more and more employees to act on offers from less-regulated and better-paying firms, as performance becomes less of a driver for remuneration among European banks.

In turn banks have been forced to look at other methods of making up the shortfall to prevent staff walking into the arms of less regulated competitors, such as hedge funds. An example of this has been cash allowances, which are a form of fixed compensation that do not generally require a corresponding increase in benefits costs as base salary increases do. However, both are forms of guaranteed cash with no variable link to performance, which is far from satisfactory from an employee standpoint.

Losing out
The drain of good employees aside, the pay-cap also puts increasing stress on banks to hike salaries on an overall basis in order to retain their staff and meet current industry remuneration standards. Now, a majority of banks are planning to increase cash allowances to compensate for the bonus cap for impacted risk-taking staff, as well as enhancing their broader employee value proposition beyond pay elements. In shifting variable compensation to fixed compensation, EU banks will be slashing variable pay such as bonuses, despite banks based outside of the EU still continuing with variable pay options. This could skew the market not only away from banks and to less-regulated financial services, but also to banks stemming from other geographic regions.

The remaining question is how will this shift from variable to fixed compensation impact the market dynamics for talent outside the EU between non-EU based banks and those based in the EU. Since banks based in the EU must apply the same cap rules to their risk-taking staff no matter where they are located in the world, fixed compensation could rise more broadly across other markets as well, leading to less pay for performance. As we’ve seen compliance heads flow out of regulators and into the private sector with the lure of better pay, it seems obvious that high-performing bank employees will do the same.

In general, financial services employees enjoy a mixture of fixed and variable compensation, with the latter largely related to performance. This has cultivated a competitive corporate culture within and between many financial firms. In public, this culture is often criticised for pushing employees to work obscene hours and for fostering cut-throat tactics between colleagues. However, this culture is also to some extent the backbone of our liberal economy and helps drive profits and ensure strong performance.

With the CRD IV rules, EU banks are prevented from rewarding such performance, have become less competitive and as a result, are losing some of their best employees in the process. Problematically, it has become apparent that the strongest employees typically have the experience needed in order to take managed risks. With banks losing out on this talent pool, compliance and risk management has become that much harder. And for Europe, this is a concerning development, as the fragile economy by no means is in a state where the best financial heads are expendable.