The recent European Banking Authority draft guidelines on pay and bonus policies have opened a debate on the impact these changes would have on the asset management industry, especially among small firms.
The EBA guidelines seek to clarify how firms and national regulators should interpret and apply the remuneration rules in the latest version of the EU’s Capital Requirements Directive (CRD IV).
The draft guidelines set out criteria for whether particular aspects of remuneration should be classed as fixed or variable. The EBA says these new rules must be applied across the sector and remove the possibility for individual countries to apply exemptions.
According to the guidelines, not only asset managers belonging to banks but also independent asset managers who are within the CRD IV legislation would be affected.
CRD IV, which covers institutions from larger banks to smaller firms such as broker dealers or commodity traders, gives European member states flexibility to apply the remuneration rules in a proportionate way.
That means these firms can implement the pay rules according to their size, internal organisation, and nature and complexity of their activities.
Currently UK regulators have put in place a proportionality threshold such that the bonus cap does not apply to smaller firms or firms whose operations are relatively simple and non systemic, but the new EBA guidelines will remove this.
Specifically, the EBA proposes removing the ability for firms to disapply the CRD IV “Pay Out Process Rules”. These require deferral of 40 per cent to 60 per cent of bonuses and payment of 50 per cent of bonuses in instruments.The rules also cap key staff bonuses at twice their fixed salary and require at least 40 per cent of bonuses to be deferred for at least three years.
The Association for Financial Markets in Europe estimate that implementing the legal interpretation from EBA would lead to a 12-fold rise in the number of companies affected by the rules.
The proportionality exemptions rule proposed by EBA is the biggest change and most surprising aspect of the guidelines, say experts.
The net effect of applying a bonus cap to asset management firms as well as banks could be that thousands of employees not currently affected by the rules could have their bonuses subject to scrutiny and tougher regulation.
The Investment Association response to guidelines states: “Instead of fostering an EU-wide approach and ensuring that all asset managers are treated fairly, the EBA’s approach will create distortions in the market which can be avoided by applying the different regimes under CRD appropriately and proportionately.
“The EBA’s error of law in applying proportionality in the manner proposed will only lead to national supervisors needing to exercise their discretion to not comply with the guidelines.”
Investment Association senior adviser on regulatory affairs Angus Canvin says this proposal from the EBA is another step to extend banking regulations to asset managers.
He says: “The idea behind the remuneration policy is to align the banker to the bank’s balance sheet. For asset managers it is a completely different scenario.
“The EBA one is an unusual position to take as when it comes to financial stability [asset managers] have a different set of risks.”
Mercer partner Sophie Black adds that the application of remuneration rules to other investment firms is “an erroneous step” as asset managers do not pose the same systemic risks as banks.
The IA response states: “Where asset managers are subject to group-wide remuneration policies we would encourage EBA to allow institutions to align their remuneration policies with the interest of investors.
“Where asset managers are owned by banks or insurers they may have to follow the remuneration policies of their parent institutions. Remuneration policies designed for banks rightly take account of the need to protect depositors and ultimately the taxpayer but are not aligned to and do not take into account the interest of investors.”
Canvin explains if the guidelines are really adopted it will mean that most UK investment firms will have to apply the full set of CRD remuneration requirements.
“That means setting payout instruments, deferred variable remuneration, most of the firms will also have the obligation to create a remuneration committee and they will have no variable remuneration for control functions and will have a bonus cap,” he says.
He adds: “Quite a lot of our firms are paying a very small fixed salary and they pay high bonuses to talents around the world. If they have a bad year they are able to cut their bonuses to zero and keep a fixed cost for the balance sheet really small.”
The bonus cap would force fixed salaries to increase, because in a successful year the employee concerned could not be paid with an increased bonus, as it will be capped at 100 per cent of fixed pay or 200 per cent with requisite shareholder approval.
According to experts, the increase of fixed costs will undoubtedly be a competitive disadvantage and will increase compliance costs and operational costs.
Higher fixed costs for fund managers will normally result in higher management fees for investors, IA’s Canvin adds.
Canvin says: “This would drive fixed salaries up. Higher fixed salaries is equal to higher fixed costs and so that’s equal to higher fees.”
Canvin says the extension of the remuneration policy rules to asset managers could in fact disrupt the relationship between the manager and the investors.
With a capped bonus, a fund manager will then not try to get better performance in his fund as he will not be rewarded with a proportionally higher salary.
He says: “It strikes at the very heart of the relationship between the manager and investors because the manager is entrusted as a professional that manages the money according to the mandate and the risk appetite set by the investors.
“The alignment of interests is therefore complete and moreover that’s bolstered and supported by the fiduciary obligation that the manager owes to the investors because he is managing their money.”
If the EBA remuneration rules are implemented there will also be an uneven playing field between firms under the CRD IV and those outside its scope.
Outside the EU, investment managers and other key staff would not be subject to the bonus cap or any of the EU pay requirements. This makes it easier for asset management companies outside the EU to compete for staff with EU asset management companies.
Black says: “The bonus cap policy will change firm’s business models as this will increase their fixed pay making them less competitive and making their ability to recruit difficult.”
Pinsent Masons senior practice development lawyer Graeme Standen says more people would have to follow the new guidelines and this will cause “quite a pain” for compliance costs as well as from a competition point of view, especially against competitors outside the EEA region.
Pinsent Masons legal director Suzannah Crookes adds: “If the guidelines are implemented, European roles in the asset management space will look less attractive. London is a key financial centre but if these rules are finalised US firms could attract more managers from Europe.”
The Wealth Management Association response to EBA states that the rules “raise competition concerns that the EBA does not seem to have considered”.
PwC asset management remuneration reward leader Tim Writht says: “Whether this will apply or not is not clear yet. If it does then it’ll cause competitive challenges, as firms would need to follow stricter requirements.
“The fixed costs going up will not be a major problem for employees, who will get more money, but for the business which has to comply. Firms could have done more in preparation to these changes.”
However, Black says “we are a long way off” a final agreement on the proposed guidelines with many firms still waiting for further details and clarifications on the new rules.