EU Regulation Weakens Bank Efforts to Manage Performance and Risk Management, Says New Mercer Survey

• Majority of EU-based banks plan to increase use of non-performance linked cash allowances or raise base salaries to manage within imposed bonus cap and offset lower bonus opportunities
• 70% of EU-based banks are seeking approval for increasing bonus cap to 200%
• 2013 sees rise in number of US banks applying malus in employee bonus payouts

The Capital Requirements Directive IV (CRD IV), European Union regulation which has placed a cap on variable pay in the EU’s banking sector, is weakening efforts by EU-based banks to manage performance and risk through pay, says a new survey by Mercer. The consultancy’s report shows 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.

These findings come from Mercer’s Global Financial Services Executive Compensation Snapshot Survey which analyses pay information amongst 78 financial services organisations, including 44 banks in 18 countries. The report surveyed emerging pay practices related to changes in pay mix, application of malus conditions and clawbacks, strategies for addressing CRD IV restrictions and the definition and number of material risk-takers to which regulations apply.

According to Mark Quinn, Head of Talent at Mercer UK and a specialist in Financial Services remuneration, “High-performing employees expect remuneration comparable to their peers, but CRD IV restricts EU-headquartered banks in what they can pay in performance-related compensation. They’re looking at other methods of making up the shortfall to prevent staff walking into the arms of other less regulated competitors, such as hedge funds. Cash allowances 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.”

Since 2008, banks have made much progress structuring pay so that it allowed for appropriate consideration of risk-adjusted outcomes and conduct/compliance behaviors over a multi-year timeframe. Mercer’s report shows that organisations continue to try to strengthen the link between performance management and compensation, introducing individual risk-related factors in performance management and strengthening bonus malus/clawback conditions.

There is also strong evidence that banks are applying malus conditions, i.e., actually reducing or not paying deferred unvested awards when lower performance, non-compliance or misconduct occur. In 2012, 62% of banks applied malus with it being more prevalent amongst European banks (82%) compared to North America (25%).  But in 2013, the proportion of North American banks that applied malus increased to 42%. Almost half of banks said that malus was applied to individuals due to non-compliance or misconduct while almost one-third said that it was applied because of poor performance.

“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”, says Vicki Elliott, Mercer’s Global Financial Services Talent Leader. “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.“

Mercer has observed that in some cases banks are 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.

Strategies to address CRD IV
When asked about their strategies to address CRD IV rules on remuneration, 70% of EU-based banks said they will request approval from shareholders or the parent company to extend the variable pay cap to 200% of total fixed compensation.   In addition, 63% of EU-based banks are implementing or planning to implement base salary increases while only 13% of those based outside the EU will do so. Fifty-five percent of EU-based banks and 47% of non-EU based banks are planning to increase cash allowances to compensate for the bonus cap for impacted risk-taking staff. At least 20% of organisations in the EU and also of organisations outside the EU are enhancing their broader employee value proposition beyond pay elements.  The survey also found that some EU participants are increasing the use of long-term deferred compensation (11%) and lengthening vesting periods (11%). Only 5% will be using “Bail-in” convertible bonds as a long-term compensation vehicle.

Conversion of Variable to Fixed Pay
In shifting variable compensation to fixed compensation, 27% of EU-based banks said they plan to discount variable pay, something that no bank based outside the EU intends to do. However, 39% of banks in the EU said they plan to adjust ratios on an individual basis which may or may not include some discounting.  “If no discounts are applied in the shifting of variable pay at risk for performance to fixed guaranteed pay, then the ‘risk-adjusted value’ of total compensation to the individual has actually increased,” says Dirk Vink, Executive Compensation Consultant and Project Manager for this survey.

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-takers” 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.