The new stealth-cap on City bankers' pay: £425k

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Welcome to the new unofficial banking pay cap

Welcome to the new unofficial banking pay cap

Sometime in the next few days, the British Parliamentary Commission on Banking Standards is expected to produce its much-anticipated report on the future of British banking. If rumours are accurate, the report will say that 'top bankers' in the UK should have their bonuses deferred for 10 years.  This would amount to a cap on compensation in the City of London, said experts.

"If you ask someone to wait ten years for a bonus, they will effectively discount it to zero," said Jon Terry, a partner in the reward and compensation practice at PWC.  "The deferred element will be disregarded, and the policy will simply have the perverse effect of making individuals focus entirely on the immediate short term cash element of their bonus - thereby increasing risky behaviour for short term gain."

Peter Hahn, a lecturer in the Faculty of Finance at Cass Business School, said there are too many uncertainties over 10 years for bonuses deferred that long to be meaningful: "What happens if someone leaves, if someone retires, if your boss changes, if the institution you're working for decides to exit your area of business?"

The Commission's report is expected to be released before George Osborne's Mansion House speech this Wednesday. It comes at a time when the European Union is also proposing to broaden the definition of 'code staff' who are subject to its compensation rules to include anyone earning more than €500k (£425k) in total, or whose bonus alone is worth more than €75k. It's not clear who the Commission's putative 10 year bonus deferrals would apply to, but code staff seem a possible target. If so, the combined proposals from Europe and the Parliamentary Commission would make it pointless for bankers to earn incremental bonuses once their total compensation hits £425k - beyond that point, punitive deferrals would make additional bonuses meaningless.

This is precisely the intention, said Terry. "The regulators would love to pressure banks to reduce compensation levels," he said.

Mandatory bonus deferrals are already a problem for banks, which have lost control of their compensation costs as a result of greater commitments to pay deferred bonuses in future. The situation is exacerbated by the fact that while banks have to account for deferred bonuses at par value, bankers who receive them typically apply a substantial discount rate. An individual will typically discount a three year deferred bonus by 30-50% at the point it's awarded, said Terry.

When it comes to deferred bonuses banks are therefore not getting value for money. The longer the deferrals, the less value they get. But they do have options.

Option number 1: substantially increase salaries    

In the first place, banks can always increase salaries substantially. It's still worthwhile paying more than £425k, as long as it's all in cash.

Terry said this is the option banks are going for. UBS, for example, was said to increase salaries for its code staff by as much as 25% last month. This was partly in response to the European Union's bonus cap, which says that banks will only be able to pay bonuses equivalent to 2.5 times salaries for the year starting 2014. However, it may also have had something to do with UBS's new five year bonus deferrals: long-deferred bonuses at UBS are worth less now; salaries have increased to compensate.

Option number 2: pay less than £425k 

The other option is clearly for banks to simply pay people less than £425k. Terry said this isn't on the cards for the moment and that most banks are simply planning to hike fixed pay.

However, high fixed costs are a challenge in an industry with volatile revenues. Over the long term,  £425k has the potential to become an unofficial cap on bankers' pay in the European Union - especially if it's overlaid with ten year deferrals. Banks won't want to pay salaries of more than £425k for fear of committing to a high fixed cost base. And bankers' won't want to receive more than £425k in bonuses because long deferrals will make the increment meaningless. Touché: a new ceiling for banking pay.

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