The EU's Capital Requirements Directive CRD IV has imposed a bonus cap on credit institutions and investment firms with the intention of discouraging the excessive risk-taking with client monies that contributed to the financial crisis. However, the inappropriate application of this bonus cap to principal trading firms now has the potential to result in the perverse effect of actually increasing risk, whilst hurting market quality.
Under CRD IV, variable remuneration is limited to 100% of fixed remuneration, or 200% with the approval of shareholders. Proprietary trading firms and FIA EPTA members that would be forced to apply the bonus cap would have little option but to significantly raise fixed salaries to maintain total remuneration, increasing fixed costs and reducing the capital buffers needed for times of stress, which leads to additional risks to financial stability. The extra fixed costs will result in wider spreads and higher execution costs, which are ultimately borne by all investors. The need to hold more own funds could even drive some firms out of European capital markets.
FIA EPTA members are not credit institutions. They trade in financial instruments using their own money at their own risk. They do not have clients, do not take deposits, and do not hold client moneys.
Remuneration structures for member firms generally consist of low basic salaries and potentially high bonuses that are dependent on firm-wide, team, and/or individual performance. This fosters prudent risk management amongst employees. Moreover, in times of stress firms are able to withhold bonus payments to strengthen their capital base. In this way variable remuneration actually promotes prudential safety rather than increasing prudential risk.
Principal trading firms leverage advanced technology to provide liquidity to markets. As such, they do not compete with credit institutions for personnel but rather with global tech companies and start-ups. The bonus cap threatens this model, and so puts principal trading firms at a real competitive disadvantage versus other employers whose model allows them to offer larger fixed salaries. Firms subject to the bonus cap already report recruitment losses to third country firms or technology companies such as Amazon, Apple, Google and Microsoft, who are also competing for the same programming and quantitative talent.
FIA EPTA considers that imposing the bonus cap on its member firms offers no financial stability benefits and believes that it prevents the sort of flexible remuneration policies that align an individual’s behaviour with the risk appetite, values, and long-term interests of principal trading firms.
The term 'investment firm' covers a wide range of financial institutions, ranging from large institutions holding billions of euros of client money to smaller trading firms that trade their own capital at their own risk and that do not have external clients or client monies. While the CRD IV provisions may be highly relevant to those large institutions, they are inappropriate and disproportionate for principal trading firms, which typically do not pose systemic risks (they are not ‘too-big-to-fail’).
FIA EPTA welcomes the recognition by the European Commission that the current CRD IV framework for investment firms needs to be reviewed. The work that the European Banking Authority (EBA) has carried out in this regard is also valuable. Late last year, the EBA published a well-considered report that proposes differentiated prudential requirements for investment firms based on the nature of their business and associated risks.
The EBA distinguishes investment firms according to 11 categories, with FIA EPTA members mainly falling within Category 9, which covers firms dealing on their own account with no external customers. We see no justification for applying the bonus cap indiscriminately to all investment firms regardless of size, scope of business and complexity, and have therefore argued in our response to the EU Commission's consultation on the bonus cap that it should not be applied to Category 9 investment firms.
That said, we support the appropriate deferral of bonuses as a means to promote prudent risk management. But the proposed minimum three to five-year deferral period and the requirement to defer up to 60% of variable remuneration are disproportionate and inappropriate to the activity of Category 9 investment firms, whose trading and funding cycle is typically completed in a matter of days. Instead, we propose the deferral of 50% of variable compensation for a one-year period for sums above an agreed minimum threshold.
The requirement to pay out at least 50% of bonuses in shares or other instruments is also inappropriate. Paying bonuses in cash under a profit-sharing scheme, which remains subject to full forfeiture, is a far more effective disincentive to imprudent risk-taking. Equity-based incentives, on the other hand, are much less effective, complex to administer, and costly to implement.
We also think that the rules disadvantage EU firms and their subsidiaries abroad and undermine capital markets at home. Applying CRD IV to the U.S. and Asian subsidiaries of European proprietary trading firms places them at a competitive disadvantage against other market participants. And because no other jurisdiction has applied quantitative restrictions on remuneration to investment firms, this could preclude third country firms from performing investment activities in the EU, as the Commission may not be able to regard them as subject to equivalent legal requirements to those covering EU firms.