The end of the bankers’ bonus cap: raising the ceiling, or lowering the floor?
I’m currently considering what to do with the design of a tricky area of a planned extension. Those of you who have met me (in person rather than on Zoom) would appreciate that an area with clearance of about 6’6” might technically work, but wouldn’t exactly be roomy. I’m faced with a dilemma – a substantial bit of rebuilding of the structure to raise the ceiling, or undoing previous building work to dig out an area and lower the floor. I won’t string out the analogy any further than I need to, but it provides a perspective on the practicalities for banking employers of being liberated from the bonus cap.
Unintended consequences
It’s widely thought that many of the effects of the bonus cap were unintended in nature. The bonus element of bankers’ pay was limited for ‘material risk takers’, but fixed pay was increased to ensure that total compensation remained broadly in the right ballpark. The drivers for this were a global talent market in banking. Even banks that weren’t global in operation themselves would be competing for talent locally with those that were and, in those organisations, issues of internal consistency generally levelled compensation across the globe. There were certainly difficult cases at the edges, with some significant anomalies and absurdities, but broadly speaking total remuneration was not directly impacted by the cap. What did of course happen was that fixed pay was increased to compensate, and thus was born the absurd concept of the ‘role-based allowance.’
Fixed pay had been on an upward trend since the financial crisis. Prior to 2008, a typical Managing Director salary was £175k, even in seven-figure total remuneration packages. The early days of remuneration regulation saw the introduction of a requirement to achieve a balance between fixed and variable pay. It had been felt by regulators that excessive reliance on variable compensation led bankers to take outsized risk and become dependent on a baseline level of variable pay. Base salaries quickly rose to settle around the £300k mark for an MD by the early 2010s. Whether that is the ‘right’ level is open to debate, but at the time it was met with consternation by many finance or risk directors who saw their fixed cost base increasing significantly. I remember one CRO saying “we’re breaking the business model”, reflecting a reduction in the alignment between variability in revenue and flexibility in staff costs.
Complications
The bonus cap exacerbated that change in the staff cost model and added two further significant complications that worked in diametric opposition to regulatory objectives. The creation of ‘role-based allowances’ meant that all but the highest total compensation packages were significantly less closely linked to performance, meaning that effectively poor performers or extreme risk-takers were insured from the consequences of their actions. In addition, the reduced ‘at risk’ proportion of total pay meant that the disincentive effect of malus and clawback, a mechanism to address financial and (increasingly) non-financial misconduct was diluted. UK regulators were commendably clear sighted in understanding these consequences when CRD IV was moving through the corridors of Brussels nearly 10 years ago. And it’s the removal of these effects that is their driver for the abolition of the cap. The UK government might have other drivers that are beyond the scope of this article.
As an aside, reducing the level of leveraged risk taking and lowering the flow-through to high bonuses within banking has been broadly achieved compared to pre-2008, by way of a number of regulatory mechanisms other than the bonus cap. The clamp down on leverage ratios, prudential adjustments to revenues derived from Level 3 assets (the most illiquid and hardest to value) and similar measures to increase capital adequacy and improve revenue recognition standards have had that dampening effect. The amount of capital required to generate £1 of variable remuneration has significantly increased compared to 2008.
Going into reverse
The missing piece is how the unintended effects of the bonus cap might be reversed in practice. You would imagine that the hope and expectation of regulators is not that the ceiling is lifted and that balance is achieved by bonuses increasing as a significant multiple of current fixed pay. As I mention above, that is unlikely anyway given the current economics of banking. Regulators’ (and no doubt Remcos’) hopes therefore will be that the floor will be lowered, i.e. role-based allowances will be converted back into variable pay, although the earlier increase in salaries is now deeply embedded. How quickly might that take effect? We might see a very mixed economy in this space for a number of years and a difficult transition period. Among the questions organisations might ask will be:
· Should we immediately put new joiners and new promotions on a newly shaped package, without role-based allowances and high-levels of fixed pay, or does the inequity of a two-tier workforce create too many challenges, not least in allocating bonus pools?
· Do we have the contractual right to remove role-based allowances? The likelihood is there is no unilateral right of variation on the part of the employer, so how do organisations go about getting express consent – and would extreme measures such as fire/rehire be considered?
· How should executive director remuneration policies reflect this change? Many investors have long wanted a return to more ‘normal’ relationship between fixed and incentive remuneration as compared to other FTSE executives and this might be reflected across bank executive committees, whose pay structure is often aligned.
· In a two-tier pay structure, do we need to change how tariffs for conduct-based malus adjustments get reflected – as a percentage of total pay, variable pay etc?
Organisations that don’t face quickly into the change in pay structure envisaged by the end of the cap might be storing up a myriad of difficulties in performance, conduct, pay equity and other employment issues. Those issues will be messier to fix the longer they are delayed, when the alternative is quickly addressing a change that bank employees will be expecting.
It all comes down to culture
As with any significant change that impacts people en masse, it will come down to organisational culture. Are your employees aligned to the organisation and pointing in the same direction, or is it an ‘everyone out for themself’ environment? Will they be willing to go along with a change that they can see is for the greater good, or will only threats and enforcement have any effect? Do your leadership show the way by example, or is the messaging from the top different from the actions people see?
While I recommend organisations tackle a change in pay structure head-on, an audit of organisational culture at the outset is a very important step. A thorough examination such as this will help foresee problems and build the vision that any good change management exercise demands.
Of course, an alternative is doing nothing until forced to, after all regulators are not demanding any immediate changes. But rather like my building conundrum, the earlier that organisations visualise what they want their finished outcome to look like, the easier getting there will become.