The European Banking Authority(EBA)has publishedthe findings of its research into banks’actions in response to the limits on variable pay imposed by CRD IV (i.e. 100% of fixed pay, or 200% if shareholders approve). It expressed the view that the annual ‘allowances’ some banks were using to supplement executives’ salaries and other fixed pay should not qualify as fixed but should instead be treated as variable.

Re-categorising these allowances as variable pay would mean the banks concerned will almost certainly have breached the CRD IV limits on variable pay if, as will be the case for many, full use had been made of those limits.Consequently these banksmayhave been making illegal payments to the executives concerned.Furthermore,some may also be acting outside the powers given to them by their shareholders (e.g. if they have obtained shareholders’ permission to extend the limit from 100% to 200%). Unsurprisingly the EBA has indicated that it expects national regulators to put a stop to these practices immediately.

Inevitably, given the size of our banking sector and the historical prevalence of variable pay practices here, many of the so-called offending institutions are in the UK.However the UK’s Prudential Regulation Authority (PRA), in a practical mood, has said that it is too late to change things for this year.

So that’s all right then?

Not really.The first depressing aspect is the apparent level of surprise and outrage being expressed by commentators and various EU bodies. In order to preserve their underlying cost base and at the same time retain key staff, banks had no real choice other than to follow the path they did – any other route would have risked compromising cost flexibility, pay competitiveness and even the scope for clawing back variable pay in the event of any future problems.This now seems to be a likely reality.  Plenty of people (us at Hay Group included) warned that this would happen and that the industry would have been better advised to fight the proposals from the outset rather than attempting to circumvent them once they became law.

The second depressing aspect is the collapse of the UK’s legal challenge.  The UK’s success record at the European Court of Justice is poor and the Chancellor has clearly concluded that this fight is not worth taking further.

Thirdly, the debate adds to the uncertain and unhelpful atmosphere surrounding the banking sector as a whole.  Although the results of the lateststress test seem to be both the best and most robust yet, the outlook for the European banking sector still looks far from rosy.

What’s going to happen?

Unfortunately our politicians and regulators seem set on discouraging new investment in European banking operations byimposing an ever more inflexible staff cost model, making it difficult to pay high performing staff appropriately, and adopting a penal regime requiring responsible executives to rebut a presumption of guilt in the event that something goes wrong.

If nothing changes I would expect to see a gradual shift of business away from European banking centres such as London, Paris and Frankfurt towards the US and the Far East.  I say gradual because it is less likely that operations will shift wholesale overnight than new investment will go that way.  Part of this drift willinevitably be driven by the faster growth of Far Eastern economies (primarily China) but part will certainly flow from an uncertain regulatory regime that has becomeincreasingly unfriendly towards financial services and bankers in particular.

So what should we do?

Executive pay is a symptom of the industry’s problems not their cause; banks must get the key issues right including their business models and the nature of their services.  Positive changes are being made on these fronts but they attract much less focus and airtime than bankers’ pay and there is therefore a risk that they may fail to have the impact needed to rejuvenate the sector and create a financial services industry that is both profitable and socially useful.Get that right and executive pay should ultimately follow.

In the meantime however, companies in the sector should pay close attention to their changing business models.  To the extent that regulations allow, pay structures should support changes made to these models and reward behaviours and outcomes that move their companies’ businesses in the right direction.  Oh – and banks will clearly want to see the final guidance from the EBA concerning the definitions of fixed and variable pay due in early 2015!

Simon Garrett, Director, Hay Group