Of the many talking points emerging from Friday’s “mini-budget”, one of the most controversial was the Chancellor’s announcement that the bankers’ bonus cap is to be scrapped, as part of attempts to attract talent to the City.
The bonus “cap” (more accurately described as a limit on the ratio of a bonus to fixed pay) applies to UK banks, building societies and designated investment firms, and is set out in PRA and FCA rules. These rules implement the Capital Requirements Directive (EU Directive 2013/36/EU) (“CRD”) which was adopted in 2013 following the financial crisis of 2008, in the face of a (subsequently withdrawn) legal challenge from the UK Government.
The effect of the cap is to limit the size of an employee’s bonus so that it is no bigger than 100% of their fixed annual pay, or 200% if there is approval from the shareholders. Following the introduction of the cap, there was a clear increase in employees’ salaries and the introduction of other fixed allowances to compensate for the limitations on bonuses.
Recognising that the strength of the UK economy depends on a strong financial services sector, on 23 September the Chancellor announced that the cap would be scrapped, as a means of attracting global banks to create jobs, invest and pay taxes in London, over the likes of Paris, Frankfurt and New York.
It is early days yet and the full details of the proposal are still to be announced, but we think the key issues (which we discuss below) are likely to include:
1. When, and how, are these changes going to be made?
The UK’s CRD-implementing bonus cap rules are in the “Remuneration” and “Remuneration Code” parts of the PRA Rulebook and FCA Handbook, respectively. These rules will need to be varied or revoked to remove the 100% and 200% bonus caps.
The PRA and FCA usually vary or revoke their rules by consulting on the changes they would like to make; considering the responses to their consultations; making their final rules; and arranging for them to come into force at a future date. It could therefore be many months before the caps are removed. So many months, in fact, that the current rules might still be in force when banks make their remuneration decisions for the 2022 calendar year, in early 2023.
If the PRA and FCA choose to vary their bonus cap rules, instead of revoking them entirely, they might, for example, remove the 100% and 200% caps (the “narrow bonus cap rules”), and keep the rules that require firms to:
- “ensure that (1) fixed and variable components of total remuneration are appropriately balanced; [and] (2) the level of the fixed component represents a sufficiently high proportion of the total remuneration to allow the operation of a fully flexible policy on variable remuneration components, including the possibility to pay no variable remuneration component”;
- defer bonus payments, in a way that means they are effectively released over a period of up to 7 years; and
- pay a proportion of each bonus in shares.
Until the timings are clarified, firms may have to operate with two separate sets of compensation spreadsheets for the 2022 compensation year. One where the cap is removed and the other with the cap still in place.
2. Which businesses will the changes apply to?
The narrow bonus cap rules apply when UK banks, building societies and designated investment firms want to pay bonuses to individuals who perform certain roles.
The UK government is clearly expecting the PRA and FCA to revoke the narrow bonus cap rules for individuals working in banks. It is not yet clear whether they will also be removed for individuals working in building societies or designated investment firms.
Although the narrow bonus cap rules do not affect individuals working for UK alternative investment fund managers, UK MiFID investment firms or UK UCITS management companies, the FCA’s wider remuneration rules do affect these people. It is not yet clear whether any of these rules will be varied or revoked, as well.
3. Will the rules on guaranteed remuneration stay the same?
The rules currently stop UK banks, building societies and designated investment firms awarding pay or providing guaranteed variable remuneration unless:
- it is exceptional
- it occurs in the context of hiring new employees
- the firm has a sound and strong capital base, and
- it is limited to the first year of service.
It is not clear if these requirements will also be scrapped as part of the Treasury’s measures to boost competitiveness.
However, the Chancellor also spoke in the mini-budget of a desire to reaffirm the UK’s status as the world’s financial services centre by implementing an “ambitious package” of further regulatory reforms later on during this Parliament.
We think that the rules on guarantees are likely to stay the same as there is no indication that the Government wishes to break the link between performance and reward.
4. What about the split between cash and equity?
The Remuneration Code also contains requirements stipulating the composition of variable remuneration, including in some cases requirements for compensation to be split between cash and equity awards.
The rationale for requiring bonuses to consist partly of equity in the business is to ensure that risk-taking decisions are more closely aligned with the long-term interests of the firm.
Our view is that the rules on the split between cash and equity are likely to remain unchanged.
5. Will there be changes to deferrals or malus and clawback?
Under the Remuneration Code, variable remuneration must be subject to:
- deferral (i.e. it is not entirely payable up front)
- malus (it can be reduced before payment in certain circumstances such as the subsequent discovery of misconduct or financial results on which the bonus was based are restated), and
- clawback (it can be recouped from the recipient in the same circumstances in which malus can be implemented).
We think substantive changes to these rules are unlikely, especially since they may be regarded as essential if the size of some bonus awards significantly increases.
6. Can banks reduce employee salaries to compensate for higher bonuses?
The Chancellor argued in the mini-budget that all the cap achieved was to push up basic salaries – or drive activity out of the UK – and did not limit total remuneration.
Many may expect that, following the removal of the cap, the fixed element of compensation (such as basic salary) will shrink whilst the variable (bonus) element will be increased. However, for existing employees this will involve implementing a change to the individual’s employment contract. Fundamental terms such as salary cannot be reduced by employers unilaterally, so employee consent will be required.
Banks and other relevant firms (if any) may need to be creative if they are to seek to reduce base salaries – they could make participation in a new enhanced bonus scheme conditional on the employee’s agreement to reducing their salary, or potentially resort to imposing the changes unilaterally after a period of consultation (despite the legal risks).
7. Will bankers get bigger bonuses on top of bigger salaries?
Banks will have greater flexibility when bidding for star bankers by being able to offer larger bonus earnings potential than is currently the case. The added flexibility may also see a greater spread of overall pay amongst bank employees, with the best performers receiving significantly more than the weaker ones.
This may liven up the recruitment market, with both star performers and the lower rewarded bankers who feel undervalued seeking to maximise their reward.
Can employers make bonus promises which are subject to the lifting of the cap by a certain point in time? We think this is possible, with careful drafting.
8. Will role-based allowances stay the same?
What will happen to role-based allowances?
These were introduced to increase fixed pay for taking on certain roles, with a consequential increase in the maximum bonus that could be awarded. We think it likely they will be phased out and replaced with a simpler and more flexible pay structure, whereby the employee receives only a fixed salary and the right to participate in an entirely discretionary bonus scheme. This would give the banks greater flexibility to link employees’ compensation to the financial performance of the bank and the individual employee. Legally, they would be an easier target for reduction than basic salaries, as they are often drafted in a way which allows them to be withdrawn.
9. Will employees ask to “cash out”?
If an employee is entitled to deferred compensation for prior years, will the new rules allow their employer to pay the deferred compensation out in cash now, perhaps for a discount, before cancelling the deferred arrangements?
We think this is unlikely to be possible as it is likely that the regulators will still wish firms to be able to operate malus adjustments to deferred compensation.
10. Will it attract global talent to the City?
Our view is that these changes may well encourage international banks to come to the UK, and/or to send their highest paid and most able people to the UK. This is an industry where financial rewards act as a significant incentive to the people who work in it.
Employers within scope of the rules would be wise to keep an eye out for the details as and when they emerge. We will cover this topic in greater detail when we know more.