PRA and FCA consult on removal of bankers’ bonus cap – what does this mean for financial services firms?

On 23 September, the then Chancellor, Kwasi Kwarteng, announced a series of Government measures in his mini-Budget. Amongst the measures was the removal of the cap on bankers’ bonuses that was first introduced into Prudential Regulation Authority (PRA) and Financial Conduct Authority (FCA) remuneration rules in 2014 as part of a package of EU pay reforms. The cap currently applies to material risk takers within UK banks, building societies and PRA-designated investment firms, and operates so that a banker’s bonus cannot be higher than 100 per cent of their fixed pay, or 200 per cent with shareholder approval. Today, the PRA and FCA published a consultation confirming their intention to remove the current bonus cap requirements with the aim of ‘strengthen[ing] the effectiveness of the remuneration regime’. This blog post summarises the consultation’s key messages and considers the impact of the regulators’ proposals on financial services firms.

What does the consultation say? 

At a high level, the consultation proposes to remove limits on the ratio between fixed and variable pay and related provisions on shareholder approval and discount rates by amending and deleting the relevant PRA and FCA rules. However, the consultation makes clear that firms would remain subject to the existing provisions in the PRA and FCA rules that require a firm to:

• set an appropriate ratio between the fixed and variable components of total remuneration;
• ensure that fixed and variable components of total remuneration are appropriately balanced; and
• ensure that the level of the fixed component represents a sufficiently high proportion of the total remuneration to allow the operation of a fully flexible policy on variable remuneration components, including the possibility to pay no variable remuneration component.

Consequently, if the proposals go ahead as planned, financial services firms will be required to set their own ratios for in-scope individuals, allowing the ratios to reflect the individuals’ role and potential for excessive risk-taking. While those ratios will no longer be subject to a specific cap, they will still need to ensure that no individual is dependent exclusively on variable remuneration, or to an extent likely to encourage them to take risks outside the risk appetite of the relevant firm.

The consultation closes on 31 March 2023. Subject to the consultation responses, the PRA and FCA intend for the proposed changes to come into force one day after the publication of their final policy, which is currently anticipated for Q2 2023. This would mean that the proposed changes will apply to firms’ performance years starting after that date, and for most firms that is likely to be performance years starting in 2024. Note that there will be a transitional period such that remuneration awarded in relation to a performance year starting before the implementation date of the final policy will be subject to the current bonus cap requirements. The PRA and FCA encourage firms that believe they may be disproportionately disadvantaged by the timings of any final policy (most likely due to the span of their performance years) to respond to the consultation.

What are the arguments for and against the cap? 

Critics of the cap have argued that it merely inflates basic pay and consequently drives up financial services firms’ fixed costs. Indeed, the consultation states that one of the ‘unintended consequences’ of the cap is the growth in the proportion of the fixed component of total remuneration. It is fair to say that, following the introduction of the cap, many bankers’ fixed remuneration was increased to allow for higher bonuses to be paid within the cap. Some of these increases were made through the introduction of ‘role-based allowances’, fixed allowances paid to bankers for taking on certain roles. The staff working paper published alongside the consultation provides evidence that when an individual’s bonus ratio gets close to 200%, next year their fixed pay – mostly driven by role-based allowances – grows much faster, suggesting that some firms are choosing to increase fixed pay to compensate for the constraints of the cap. The PRA and FCA state that this reduces firms’ ability to adjust costs to absorb losses in a downturn, so one of the key messages from the regulators is their desire to make it easier for firms to adjust their variable remuneration to reflect their financial situation.

Another argument against the cap is that it discourages banks and bankers from moving to the UK. This sentiment is echoed in the consultation, which states that the removal of the cap could enhance UK competitiveness through two routes. Firstly, it could increase the attractiveness of the UK as a base for businesses due to greater flexibility over remuneration structures. Secondly, UK firms may be able to more effectively compete when doing business in jurisdictions such as the US and Asia, where there is no bonus cap, thereby promoting UK competitiveness in global financial markets. The removal of the cap may also allow UK banks to compete for talent against other firms such as asset managers and private equity firms, which are generally subject to less onerous restrictions. The PRA and FCA expect that their proposals will reduce ‘long-standing competitive distortions’ between firms, which according to them are ‘particularly problematic’ in the context of investment activities.

On the other hand, the announcement of the removal of the cap comes at a time of difficult economic circumstances for much of the public. Contrasted against the backdrop of a cost-of-living crisis, some may react negatively to the news of a removal of pay restraints on a historically well-paid workforce. It is, however, important to note that the removal of the bonus cap will not affect other PRA and FCA remuneration rules which are used to ensure effective risk management within financial services firms, including:

• deferral rules (which ensure that variable remuneration is not entirely payable upfront);
• malus rules (which allow variable remuneration to be reduced before payment in certain circumstances); and
• clawback rules (which allow variable remuneration to be recovered after payment).

The consultation confirms that these rules, along with rules on the holding of a proportion of variable remuneration in shares or other non-cash instruments, will remain in place under the regulators’ proposals.

However, the future of the Senior Managers and Certification Regime, which was introduced in the wake of 2008 to improve governance and accountability within financial institutions, is less clear. It was announced as part of the Chancellor’s recent ‘Edinburgh reforms’ that this regime will be reviewed in 2023, so the interplay between the two sets of rules remains to be seen. For now, the consultation explains that ‘there may be scope to improve the alignment of and interlinkages between the two regimes’ and confirms that the PRA will consider these issues further in due course.

What does the removal of the cap mean for financial services firms?

The consultation’s proposals will require financial services firms to conduct a thorough review of the remuneration structures applicable to UK-based material risk takers. Over time, this is likely to involve a move away from role-based allowances and a reduction in (or, at least, slower growth of) salaries to allow for increases in variable pay that comply with remaining PRA and FCA rules and are acceptable to shareholders. Importantly, a reduction in salary will involve an amendment to employment terms and conditions and will therefore usually require employee consent. In contrast, the move away from role-based allowances might be easier to implement depending on the terms of those allowances. No-one expects banks to change their remuneration policies overnight, so it is more likely that we will only see more immediate changes for new hires. The removal of the cap and the freedom it will give firms in respect of the remuneration structures for new hires could prompt concerns in terms of general competition and retention of talent within the EU market.

As mentioned, removing the cap would likely result in a greater proportion of pay being variable and therefore potentially less transparent. This might create additional employment law complexities, including in relation to discrimination and equal pay disputes. The consultation states that that the banking sector, in the consideration of the regulators, has high gender pay gaps and reminds firms not to discriminate on the basis of an individual’s protected characteristics when assessing performance for the purposes of awarding variable remuneration. In this context, the consistent exercise of discretion and the clear documentation of decisions will be crucial. The increased amount of remuneration will also be closely tied to malus and clawback powers, as there will be more compensation ‘at risk’. Ultimately, firms will have greater flexibility to align remuneration to the performance of the individual, hopefully increasing individual accountability and resulting in more prudent risk-taking by material risk takers.

What’s next? 

The PRA and FCA will want to consider responses to their consultation before deciding on their final rules, so watch this space for more developments. For more information in the meantime, please speak to the authors of this blog post or your usual Freshfields contact.