CRD IV - Unintended Consequence
The fourth incarnation of the Capital Requirements Directive (CRD IV) is the EU's implementation of Basel III, the international regulatory capital framework. It is one of the key responses to the financial crisis.
CRD IV sets prudential structures over capital requirements and constraints on remuneration. It came into being on Jan 1st this year. The capital requirements are well documented and are aimed at banks, but the remuneration constraints or 'bonus cap' may have unintended consequences for bank-owned asset managers. All 'significant' firms are subject to CRD IV, where the definition of significant is determined by 5 criteria; and a breach of any one of these levels leads to being classed as significant:
- Balance sheet exceeds £530 million
- Total liabilities exceed £380 million
- Annual fees and commission income in relation to regulated activities exceeds £160 million in a 12 month period
- Client money balance exceeds £425 million
- Client assets held in the course of regulated activities exceed £7.8 billion.
An important reaction to the financial crisis of 2007/08 was a realisation that remuneration policies that encourage excessive risk-taking can affect the financial judgment and risk management of investment firms. European financial regulatory bodies recognised this and have focused their rule-making on aligning effective risk management with remuneration.
Under the previous directive, CRD III, firms were required to set the appropriate ratios between the fixed and the variable component of the total remuneration that staff could be awarded. However, CRD III did not specify what this ratio should be. CRD IV has developed this and introduced a ceiling for bonuses at 100% of base salary. The variable element of a salary can therefore not exceed the fixed element. However, with shareholder approval this ratio can be increased to a maximum 2:1 (variable:fixed).
Remuneration is only one strand of CRD IV. As with any new regulation more transparent and detailed reporting is required. Firms caught by this directive have more stringent capital requirements, liquidity and financial reports to complete and return. Every significant firm has to carry out more detailed, independent and intrusive risk assessments and stress-tests and corporate governance needs to be strengthened, including an independent risk committee and the appointment of non-executive directors.
After a narrow vote in the EU parliament in 2013 fund managers running 'mainstream' UCITs funds avoided the same restrictions on remuneration. Also Alternate Investment Fund Managers (AIFMs) are now subject to AIFMD and the remuneration policies therein. So it appears that the remuneration rules within CRD IV will put managers at bank-owned asset management groups at a "significant disadvantage" to AIFMs, independent and insurance-owned fund houses.
Further, the European Banking Authority wants to widen the scope to include anyone earning above €500,000, inclusive of bonuses and apply the cap to bank staff earning a bonus of more than €75,000 when that represents more than 75 per cent of fixed pay.
If the playing field is not considered level, then high performing, well rewarded managers at bank-owned asset managers may seek a move. Investor outflows may result as some investors follow these high-performing managers.
The initial impacts of CRD IV have been seen recently in two contrasting cases. Royal Bank of Scotland has scrapped plans to increase its bonus pool after the government said it would block the move. RBS, which is 80% owned by the government, was to seek shareholder approval for bonus payouts of up to 200% of basic salaries, but the government as majority shareholder has pushed for up to 100%. The government has however adopted a softer stance on Lloyds. It is majority private-sector owned and the government's shareholding in the bank is now down to less than 25%. The government in this instance seems to be supporting a bonus cap up to at the maximum allowable ratio of 2:1.