The Central Bank of Ireland (Central Bank) published an information note in quarter 4 of 2010 called 'Impending Changes to the Capital Requirements Directive affecting (MiFID) investment firms'. This information note related to the introduction of EU legislation aimed at increasing the regulation of institutions whose elaborate payment and bonus schemes contributed to the systemic collapse of the European economy. This article will focus on the remuneration and disclosure principles introduced by Directive 2010/76/EU (CRD III).
The Capital Requirements Directive (CRD III) introduced a number of changes to the current capital requirements legislation including, inter alia, the following:
- Strengthening capital requirements for assets held in an in institution's trading book;
- Capital requirements for re-securitisations that are both higher than the capital requirements of other securitisation positions and tied to the level of due diligence undertaken on the re-securitisations;
- Enhanced disclosure requirements in relation to securitisations in the trading book and sponsorship of off-balance sheet vehicles; and
- Binding remuneration policy principles.
Of all the requirements above, the remuneration and disclosure requirements are requirements that Institutions (defined below) will be least familiar with. The Central Bank information note has not provided of specific guidance and has instead indicated that investment firms should rely on the Guidelines on Remuneration Policies and Practices issued by the Committee of European Banking Supervisors (CEBS Guidelines). While the CEBS Guidelines are detailed and provide significant direction in terms of what information is to be included in remuneration policies and disclosure requirements, investment firms may still have to implement significant changes to their internal operations to become fully CRD III compliant.
The CRD III requirements will apply to all credit institutions and investment firms who are currently authorised under the EU Markets in Financial Instruments Directive (MiFID) to which the existing CRD rules apply (together the 'Institutions'). The scope of the Directive leaves no room for ambiguity in terms of which institutions the Directive applies to.
Importantly, the CRD III remuneration requirements will apply to identified staff only. The CEBS Guidelines have provided that institutions must '…identify staff whose professional activities have a material impact on the risk profile' of the institution ('Identified Staff'). Institutions will be required to demonstrate how they have assessed and selected Identified Staff.
Unless an institution can demonstrate that they have no material impact on the institution's risk profile, the following staff will automatically be deemed to be Identified Staff.
- Executive members of the institution such as directors and the CEO;
- Senior management such as individuals responsible for heading significant business lines; " Senior staff responsible for independent control functions such as compliance and internal audit; and
- All staff who are in a position to exert influence on the institution's risk profile
Importantly, any institution who excludes any of the categories of staff set out above from the list of Identified Staff must be in a position to demonstrate clearly that such staff has no material impact on the risk profile of the institution.
A critical concept of the CRD III requirements is the self-assessment proportionality principle. Unfortunately, the Central Bank has not provided specific guidance on how to apply this proportionality principle and has referred investment firms to the CRD III Directive and the Guidance set out in the CEBS guidelines. The CRD III Directive provides that:
…. the principles should recognise that credit institutions and investment firms may apply the provisions in different ways according to their size, internal organisation and the nature.
So how do firms self-assess? This is not an easy question. CEBS provide that self-assessment is based on three sub-principles:
- Size, which includes value of assets, level of capital, as well as the number of staff or branches of an institution.
- Internal Structure, which includes legal structure, and listing on regulated markets; and
- Nature, Scope and Complexity of the institution, which includes type of clients, type of authorised activities and the national or international nature of the business activities.
This is not an easy task as any advantage taken on the basis of the proportionality principle has to be sufficiently justified by each financial institution.
In the UK, the FSA have incorporated the CEBS Guidelines in to a Remuneration Code and the proportionality principle is applied on a four-tier basis. Tier 1 and 2 represents the larger institutions, and such institutions will be required to adhere to possibly all of the CEBS Guidelines in addition to the FSA Remuneration Code requirements. Tier 3 and 4 represent the smaller non-complex institutions that will be in a position to neutralise some of the requirements of the CEBS Guidelines.
In Luxembourg, the CSSF has applied the proportionality principle by establishing two separate thresholds for Institutions to consider. The first threshold relates to Institutions that fall above or below certain monetary thresholds. If an Institution is below the monetary threshold it will automatically be entitled to neutralise certain CRD III requirements. The second threshold applies to Institutions who are above the monetary threshold and provides that if the variable remuneration for an employee of that Institution is €100,000 or less, the Institution may be in a position to neutralise certain requirements for Identified Staff.
While some credence may be paid to the UK and Luxembourg positions and it is certainly helpful in determining how to apply the proportionality principle, each Irish based institution must assess its own characteristics when deciding how to develop and implement its CRD III remuneration policies. Any decision taken on the application of the proportionality principle must be documented.
The effect of this proportionality principle is that not all institutions have to meet the remuneration requirements in the same way and to the same extent. Unfortunately, this does not mean that institutions will be outside the scope of CRD III however it does present the opportunity for Institutions to neutralise some requirements.
The neutralisation concept introduced by the CEBS Guidelines allows Institutions to render certain requirements non-applicable to their Institution. Importantly, Institutions who deem neutralisation for certain requirements appropriate for their Institution or Identified Staff, must be in a position to demonstrate the rationale for the decision to neutralise any requirements.
As mentioned above, the CEBS Guidelines are detailed and provides approximately twenty remuneration principles that may have to be applied by institutions. A number of the key remuneration requirements are set out below. " Institutions must implement remuneration policies that are consistent with and promote sound effective risk management; " Institutions must ensure that employees responsible for risk and compliance functions are remunerated independently of the business areas which they monitor and control; " Guaranteed variable remuneration should be exceptional and apply only to newly hired staff in the first year of employment; " All cash bonuses to be capped at 30% of the total bonus or 20% for particularly large bonuses; " At least 40% of any bonus must be deferred over 3-5 years " At least 50% of the total bonus must consist of an appropriate balance of shares or capital contingent instruments; " Variable remuneration, including the deferred portion, should only be paid if it is sustainable according to the financial position of the institution as a whole.
The CRD III legislation provides specific and general requirements on Institutions to disclose detailed information regarding their remuneration policies and practices for Identified Staff and to a lesser degree, provide general information regarding their institution wide remuneration policies and practices.
Again, the proportionality principle comes in to play and the CEBS Guidelines provide that 'small or non-complex institutions will only be expected to provide some qualitative information and some very basic quantitative information...' As noted above, where CRD III requirements are neutralised by virtue of the proportionality principle, institutions must demonstrate the rationale behind any neutralisations.
The remuneration disclosure requirements placed on each firm will be different and will depend to what extent the proportionality principle can be applied, however a number of key requirements which all Institutions should be aware of are as follows:
- Information concerning the decision making process used for determining the remuneration policy;
- Information on the link between pay and performance;
- Information on the most important design characteristics of the remuneration system, to include criteria used for performance measurement and risk adjustment and deferral policy;
- Information on the parameters and rationale for any variable component scheme and any non-cash benefit scheme; and
- Aggregate quantitative information on remuneration, broken down by business area; and aggregate quantitative information on remuneration, broken down by senior management and Identified Staff.
What Do Institutions Need to Do
The CRD III requirements will impact individual institutions differently and every institution is going to have to assess how it will comply with the requirements. A number of initial steps for institutions to take are as follows:
- assess how the proportionality principle can be applied to your institution;
- identify and record all 'Identified Staff'; " determine which requirements apply to your institution;
- review all existing remuneration policies and information on remuneration;
- assess whether the existing remuneration policies achieve compliance with t he relevant requirements; and
- review all legal agreements currently in place with a view to ensuring all employment contracts are CRD III compliant.
Given that the concept of remuneration policy and remuneration disclosure requirements are something Institutions will not have faced before, the initial implementation of these requirements may be burdensome on Institutions. Obviously any Institutions who are in a position to avail of the neutralisation offered by the proportionality principle should do so.
It is clear that the new remuneration principles go beyond the recommendations of the Financial Stability Board by imposing more stringent limits on the extent to which bonuses can be paid in cash, the requirement for partial deferral of bonuses and a cap on the level of bonuses relative to fixed salaries. While this is undoubtedly a step in the right direction for the larger EU institutions, it may be arguable that the proportionality principle offered by CRD II and the CEBS Guidelines does not go far enough to reduce the requirements on the smaller, less complex institutions that fall within the CRD III scope.
As the CRD III requirements evolve the Central Bank may adopt a more formal position on the proportionality principle to be applied to Irish Institutions and perhaps publish detailed guidance on how such Institutions should apply the proportionality principle. For now though, Institutions who have not already given this regulatory requirement serious attention, should take all reasonable steps to become CRD III compliant by 1 July 2011, something which may prove easier said than done.