Following a consultation in December 2022 (see more here), the Prudential Regulation Authority (PRA) and Financial Conduct Authority (FCA) have confirmed in a policy statement that the cap on bankers’ bonuses will be removed sooner than expected. The cap was first introduced into PRA and FCA remuneration rules in 2014 as part of a package of EU pay reforms 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. The removal of the cap will affect UK banks, building societies and PRA-designated investment firms, applying to performance years ongoing on 31 October 2023 as well as to future performance years. This blog post summarises the policy statement’s key points and considers the impact on financial services firms.
What does the policy statement say?
Save for a few key changes summarised below, the proposals in last year’s consultation will be implemented largely as planned. This means that, from 31 October 2023, the PRA and FCA will 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. Financial services firms will therefore be required to set their own ratios for UK-based material risk takers (MRTs), taking into account the business activities of the firm and the role of the individual.
While those ratios will no longer be subject to a specific cap, firms will remain subject to the existing provisions in the PRA and FCA rules that require them 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;
- 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; and
- ensure effective risk management through other remuneration rules, including:
- deferral rules (which ensure that variable remuneration is not entirely payable upfront);
- rules on the holding of a proportion of variable remuneration in shares or other non-cash instruments;
- malus rules (which allow variable remuneration to be reduced before payment); and
- clawback rules (which allow variable remuneration to be recovered after payment).
How does the policy statement differ from the consultation?
Guidance on setting an appropriate ratio
The PRA and FCA have drafted new guidance on the factors for firms to consider when setting an appropriate ratio between fixed and variable pay. The new guidance requires a firm to consider all relevant factors, including but not limited to:
- the firm’s business activities and associated prudential and conduct risks; and
- the role of the individual in the firm and the impact that different categories of staff have on the risk profile of the firm.
Helpfully, the new guidance also confirms that:
- a firm may set different ratios for different categories of staff (for example, it will usually be appropriate to set a lower ratio of variable to fixed remuneration for control functions than for the business units they control);
- ratios may differ from one performance period to the next; and
- when setting a ratio, a firm should consider all potential scenarios, including exceeding its financial objectives. The ratio should reflect the highest amount of variable remuneration that can be awarded in the most positive scenario. A firm should be satisfied that it has considered all relevant factors and should be able to explain its decision to the regulators if required.
Implementation
Perhaps the most important change in the policy statement relates to the regulators’ approach to implementation. The PRA and FCA have confirmed that the requirements will be effective on 31 October 2023 and will apply to firms’ performance years ongoing on that date, as well as to future performance years – this is different to (and more immediate than) what was proposed in the consultation, which removed the requirement for firms’ performance years starting after the date of publication of the final policy (being, for most firms, performance years starting in 2024). The regulators believe that, by giving firms the flexibility to restructure pay faster, they will enable them to deal with downturns, foster better market conduct and prudent risk management, and compete for and attract new talent sooner.
Importantly, the policy statement confirms that firms may, if they wish, choose to wait until a later date (for example, the start of their next performance year) before making any changes. They may also choose to keep their current approach indefinitely. In addition, the regulators will not ask firms to re-submit their remuneration policy statements for the ongoing year if they have already done so.
Other
Last year’s consultation proposed the deletion of wording in a supervisory statement which: (1) included guaranteed variable remuneration in the variable component of the fixed to variable ratio; and (2) required firms to use an annualised rate to determine the fixed pay of a part-year MRT. The feedback was that deleting this language would create confusion, so it has been retained.
What should financial services firms do now?
While firms could implement changes to their remuneration policies as early as 31 October 2023, and some may take advantage of that for new hires, it is likely to take longer for broader changes to arrangements for existing MRTs to take effect.
Firstly, firms who move away from the existing ratio will need to determine the appropriate ratio to apply in its place – and whether to apply different ratios for different groups of staff. Of course, any changes to employment terms and conditions will also generally require employee consent. And with a greater proportion of pay being variable and therefore potentially less transparent, firms will need to be mindful of additional employment law considerations, including in relation to discrimination and equal pay.
Ultimately, the removal of the cap will mean that financial services firms will have greater flexibility over how they align incentives with effective risk management and good conduct. This will hopefully discourage individual behaviours that could lead to misconduct. It may also enable firms to compete more effectively for talent – both with other jurisdictions and with other firms such as asset managers and private equity firms, which are generally subject to less onerous restrictions.
It is also worth noting that the policy statement referenced several topics from the feedback that the regulators deemed to be beyond the scope of the consultation, notably changes to deferral periods, interaction of this reform with the review of the Senior Managers and Certification Regime, treatment of buy-outs for new hires and role-based allowances for replacement MRTs. In response, the regulators reiterated that they intend to look more broadly at the remuneration rules in due course, so watch this space.
