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21 Dec 2022

First formal steps towards removal of the bonus cap in UK banks

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The abolition of the UK bankers' bonus cap has moved further forward with the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA) jointly publishing a consultation paper. However, with the final rules not expected to be out until Q2 2023, it seems likely that relevant pay for 2022 and (for most companies) 2023 will still be affected by the cap.

Unless this timeframe is changed as a result of the consultation - and there may well be pressure to do this - this means that banks will still need to operate the bonus cap for some time and that for many it will only be bonuses payable in 2025 that will benefit from the relaxation.

Background

The bonus cap limits variable pay, which includes bonuses but can include other elements of pay such as share plan awards, sign-ons and termination pay, for key employees in banks, building societies and key investment firms. In more detail, it prevents most Material Risk Takers (otherwise known as MRTs) from receiving variable pay in any year which has a value of more than their fixed pay for that year (although, with shareholder approval, variable pay can be up to twice their fixed pay and the consultation paper reports that the vast majority of affected banks have taken this authority from their shareholders). In recent years, the number of employees caught as MRTs has increased substantially and, combined with changes that the UK made which required all banks to implement the bonus cap whatever their size, the PRA estimates some 9,000 UK bankers were affected by the cap in 2021.

In September this year, Kwasi Kwarteng, the then Chancellor of the Exchequer, said that the UK would remove the cap on bankers' bonuses it had inherited from EU banking provisions. While relatively few of the other proposals announced at that time have survived, this proposal has been adopted by his successor, Jeremy Hunt, and the new Government. Given the degree of Government support there seems little doubt that the removal of the cap will go through, but the PRA and FCA are required to consult on the relevant changes as the cap is not contained in legislation, but in their relevant handbooks. The consultation period runs until 31 March 2023.

The proposals

The proposals are straightforward - they simply remove the cap. As background, the PRA and FCA provide considerable explanation for why the bonus cap is considered not to have worked and impedes competition. The UK was always a reluctant implementer of the bonus cap - the European Commission had to take it to the European Court of Justice at one stage - and the proposals set out a number of ways in which the PRA and FCA consider that its core objective of preventing risk-taking has not been met. They also note that outside the EU (and indeed within the EU, outside the banking sector), there are no bonus caps, and it is therefore considered that the UK is an unattractive place for recruitment when compared with non-EU financial centres. Other criticisms are that the bonus cap has been in place at a time when overall remuneration has increased and so there may well be a link to pay inflation, it limits the percentage of pay which can be clawed back in the case of failure, it increases fixed cost and has led to what can at times be close to regulatory avoidance activity where banks have awarded role-based allowances which have sufficient characteristics to be fixed pay, but have many commercial aspects of variable pay. In addition, the PRA notes that it has given a fair number of waivers anyway.

The cap will take some time to fall away on current proposals as firms will be required to operate the cap until the year after the cap is removed. Given implementation is not likely before Q2 2023, this therefore means that 2022 and most 2023 bonus pools will still be subject to the cap, though there may be pressure on the PRA and FCA to act quicker.

Whatever the justifications that the PRA and FCA give for the removal of the cap, few banks will be arguing against this. Instead, they will be considering how they should react to the change and what life after the removal of the cap will look like.

Life after the removal of the cap

Two particular issues are already coming to the fore.

  1. First, the proposals make clear that removing the cap does not mean that pre-2008 pay practices can return. Even if there is a sense of liberation, there will be far from complete freedom to determine pay awards. While only larger UK banks will continue to be required to defer bonuses and pay bonuses in shares for most of their MRTs, MRTs in all banks will still be subject to malus and clawback on their variable pay. Most importantly, banks must also still set an appropriate ratio/balance between fixed and variable remuneration. The PRA and FCA propose no changes here - though the position is being kept under review - and so, with the removal of the cap, it will become even more important (and difficult) for banks to determine what that ratio and balance should be for groups of employees and from year to year. Investment firms' expectations to date in implementing the IFPR regime for their MRTs has been that the FCA will take a light approach and high ratios will be acceptable, but it would be surprising if banks took (or were allowed to take) a similar approach.
     
  2. Secondly, it is thought many firms which increased fixed pay for MRTs will want to reduce it (as a quid pro quo for increasing variable pay) either by reducing salary or removing role-based allowances which were introduced as components of fixed pay. Although banks will want to have an overall policy, this will require individual agreement with particular employees, though can be implemented more easily for new hires. Given the likely time needed to work out what a new approach should be, banks would be well advised to start discussing the post-2023 environment relatively shortly. In appropriate cases, banks may be able to force through changes by saying that nil bonuses will be paid if they are not agreed, but that could be a heavy-handed approach which could give rise to legal complications if not handled well.

As we would predict an increase in the proportion of variable pay as a result of removing the cap, which can result in less transparency, employers will need to make sure they do not fall foul of their employment law obligations leading to equal pay and discrimination claims.

Next steps

Employers should be mindful of the changing landscape and what may lie ahead. Following the end of the consultation period, the FCA and PRA will consider the responses and then decide on the final rules, which are anticipated to be published in Q2 2023. 

We'll keep you updated on developments and if you have any questions on the topic please contact Nicholas Stretch, Desiree de Lima or Paul Reeves.

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