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Uncertainty remains over bank bonus cap, says expert, as EU approves CRD IV reforms

European member states have voted through a comprehensive banking reform package, against UK objections to the introduction of caps on bankers' bonuses.

However, an employment law expert warned that there were still "significant uncertainties" about how the cap, which will apply to bonuses paid from the start of 2015 reflecting performance in 2014, would work and which members of staff would be caught by it. Christopher Mordue of Pinsent Masons, the law firm behind Out-Law.com, said that banks would likely increase the salaries of senior staff to mitigate the impact of the cap.

The new rules will limit bonuses to 100% of salary in any given year, or 200% of salary with the agreement of shareholders. In addition, a minimum of 25% of any bonus exceeding 25% of salary will have to be deferred for at least five years. The cap forms part of a package of measures designed to bring European banks into line with the Basel III international banking agreement.

"The vote in favour of the bonus cap is no surprise and at least the banks have a clear timetable for reforming their bonus structures," Mordue said. "The problem is that there are still some significant uncertainties about how the cap will work and who will be caught by it. Firms now face the difficult task of overhauling their remuneration practices in a short timescale without a clear picture of the final shape of the new rules. This is likely to result in broad brush compliance approaches, including increasing salary to mitigate the impact of the cap."

He added that measures with the potential to lead to increased salaries "run contrary to the aim of aligning pay with long-term performance and disincentivising short-term and high risk practices".

The new laws were voted through by a "qualified majority" of EU member states, with only the UK dissenting. They consist of a new Capital Requirements Directive (CRD4) (340-page / 912KB PDF) and a directly-applicable Capital Requirements Regulation (1181-page / 3.2MB PDF), which will introduce the first single set of prudential rules for banks across the EU. The majority of the provisions will take effect from 1 January 2014, according to an official announcement by member states.

Under the new regime, banks will be required to set aside good quality capital amounting to a minimum of 8% of their risk-weighted assets. Just over half of this, amounting to 4.5% of assets, must be in the form of 'tier one' capital; up from the current 2% requirement. This capital must be reasonably liquid, meaning readily convertible into the cash needed to pay depositors and creditors in an emergency. Tier one capital mainly consists of shareholders' equity, disclosed reserves and other high quality assets.

The rules also provide for two further capital 'buffers' above the minimum requirements. Banks will have to maintain a 'capital conservation buffer' to absorb losses and protect their capital, and a 'counter-cyclical buffer' specific to the institution to prevent excessive lending. Member states will also be given the flexibility to impose stricter requirements than set by the legislation, for example to cushion them against property price crashes. Banks will also be required to disclose profits made, taxes paid and subsidies received on a country by country basis, as well as turnover and number of employees.

The new laws will require regulators to review the remuneration policies banks apply to senior staff, defined as "risk takers" and those staff who are earning similar amounts of money and whose "professional activities have a material impact on their risk profile". The European Banking Authority is currently consulting on draft technical standards which would act as criteria for determining which staff will be considered "material risk takers", however this consultation is not due to close until 21 August.

"Another issue is that this proposal is only one strand in an emerging web of regulation around pay in the banking sector," employment law expert Christopher Mordue said. "The UK Parliamentary Banking Commission's report just a couple of days ago also recommended significant changes in this area; including a new remuneration code, longer deferral periods for variable pay and greater use of clawback provisions."

"While these are broadly consistent with the thrust of the EU measures under CRD IV, the question is whether the UK measures will impose structures and requirements beyond those under EU law, requiring yet further changes to remuneration packages. Firms will need to ensure that they maintain sufficient flexibility to alter pay structures to meet further regulation down the line," he said.

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