One cap to rule them all

Europe's bank pay rules are dispiriting

Europe's bank pay rules will leave the runts of the litter weaker. The European Banking Authority has argued for a cap on bonuses to apply to all lenders, after publishing final guidelines on remuneration for the region's lenders on December 21.

The token concession is that national regulators may still be able to grant limited waivers on variable compensation requirements for smaller banks and fund management houses they own. These cover the necessity to defer 40 per cent of variable compensation for three years, and to pay at least half of it of it in shares or bonds rather than cash. The EBA wants the European Commission to legislate to prevent the possibility of regulatory arbitrage. What constitutes "smaller"? The EBA hasn't provided details and wants the European Commission to legislate to set thresholds for the exemptions.

It's good that regulators are clamping down on excessive pay practices that endangered the financial system, though deferring pay and clawbacks are better solutions than a crude cap on bonuses. But smaller lenders are, by definition, not systemically risky so it is hard to see why the rules apply to them. Restrictions on bonuses are likely to raise their fixed costs and leave them more vulnerable in the event of periods of trading strain. Larger base salaries have been one of the unintended consequences of the cap, which limits institutions to paying out up to two times base salaries as a bonus with shareholder approval. At big UK banks, fixed pay as a proportion of overall compensation rose from 28 percent to more than half between 2013 and 2014, according to the Bank of England.

Smaller banks will have longer to prepare for the changes, which will only take effect from the start of 2017, rather than next month. The EBA wants to give countries more time to cope with the administrative upheaval. Recall that the UK's Financial Conduct Authority said in March that as many as 1,000 firms could be captured by the regulation.

With lending conditions across Europe unusually benign, flexibility on pay may currently feel like an unnecessary luxury. But when the credit cycle turns, smaller firms could lose out.