On 24 October 2023, the PRA and the FCA issued a joint policy statement (PS) announcing that the bonus cap would be scrapped from 31 October 2023. The move follows a joint consultation paper (CP) published in December 2022, which itself gave effect to a commitment made by the government three months prior. The axing of the cap was thus widely expected, but many have questioned the rationale behind the regulators’ action, and what this tells us about the UK’s regulatory pathway outside of the EU.
What is the bonus cap?
The bonus cap limits variable remuneration to 100% of an individual’s fixed remuneration, which can be (and in practice usually is) increased to 200% with shareholder approval. The cap broadly applies to all material risk takers (MRTs) at banks, building societies and PRA-designated (i.e. systemically important) investment firms, being those individuals who have a “material impact” on the firm’s risk profile. This includes, among others, directors, senior management, and those with managerial responsibility over a “material business unit” or control function, such as internal audit.
Why does the UK have one?
The cap is a creature of the reforms that followed the global financial crisis (GFC), introduced by the EU in 2013 via the fourth Capital Requirements Directive (CRD IV) to address the excessive risk-taking that bonus culture was considered to encourage. While CRD IV implemented the international Basel III standards agreed in the wake of the GFC in 2010, these did not provide for a bonus cap, and the policy was not followed by other major financial centres outside of the EU, such as the United States. Perhaps mindful of this global competition, the UK government and regulators opposed the cap in 2013 (then-chancellor George Osborne even initiated legal action to annul it) and used what discretion CRD IV afforded to apply a light touch to implementation, for instance by exempting smaller firms.
What have the regulators done?
From 31 October 2023, the cap will cease to apply to variable remuneration. While the CP proposed that this change would apply only to performance years beginning after the effective date, the PS goes further, allowing firms to disregard the cap immediately for any portion of their current performance year which falls after 31 October. Firms are reminded that the CRD rules relating to deferral, payment in instruments and risk adjustment (including malus and clawback) continue to apply, and that the ratio between variable and fixed remuneration must remain “appropriately balanced” (although the PRA’s new guidance on this is principles-based and includes no quantitative steers).
Why have they acted?
Axing the bonus cap has been widely viewed as a political decision, initiated by a Conservative chancellor eager to prove the competitive benefits of regulatory divergence from the EU. The regulators, however, must act in accordance with their statutory objectives, and are keen in this regard to stress the move’s macro- and micro-prudential benefits, painting it as a technocratic measure which, first and foremost, advances financial stability.
For the regulators, the bonus cap has not only been ineffective on its own terms, failing to reduce risk-taking; it has also had unintended consequences adverse to the financial health of firms and, therefore, the system as a whole. With variable remuneration capped, firms have compensated by increasing base pay. This has increased their fixed costs, reducing their ability to absorb losses in a downturn, and also taken more pay outside of the purview of regulation: fixed remuneration, unlike its variable counterpart, is not subject to the CRD remuneration toolkit, making it less aligned with principles of prudent risk taking. Scrapping the cap allows firms to gradually restructure their pay, giving them flexibility to increase the proportion that is variable and thus capable of being decreased during periods of financial stress and/or reduced or clawed back in the event of later failures or misconduct coming to light.
Competitiveness is not irrelevant, though, and the regulators note that scrapping the cap also advances their new secondary objective, introduced in August by the Financial Services and Markets Act 2023 (FSMA 2023), to facilitate the international competitiveness and medium- to long-term growth of the UK economy. They also make reference to their long-standing competition objective, and state that axing the cap should facilitate the growth of new market entrants who may require greater leeway on risk-sharing to attract and retain talent.
A quick win?
As the government and regulators gear up for the root-and-branch reform of the regulatory framework demanded by FSMA 2023, they will be hard pressed to continue finding policies which marry competitiveness and financial stability with such apparent ease. For Sam Woods, chief executive of the PRA, these two goals are complementary, since “financial stability is the single most important ingredient of competitiveness in financial services”. That may sometimes be so. But more often than not they are in tension, and in this regard the scrapping of the bonus cap may be the low hanging fruit on the deregulatory tree, a quick, eye-catching win which quenches the government’s thirst for competitive divergence while advancing the regulatory priority of financial stability. More substantive divergence is likely to be hard-fought, or otherwise incremental – and rather less headline-grabbing.
Scrapping the bonus cap may be the low hanging fruit on the deregulatory tree, a quick, eye-catching win which quenches the government’s thirst for competitive divergence while advancing the regulatory priority of financial stability.