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New European Context for Remuneration at Financial Institutions

18 Nov 2011

The European Parliament and of the Council has earlier published Directives 2006/48/EC and 2005/49/EC regarding capital requirements for the trading book, for re-securitisations, and the supervisory review of remuneration policies. A new Directive 2010/76/EU of the European Parliament and of the Council, was published amending the said earlier Directives 2006/48/EC and 2005/49/EC. This new Directive, together with the practical principles for its application issued on 10 December 2010, by the Committee of European Banking Supervisors (CEBS - now the European Banking Association), constitutes the benchmark for European financial institutions to adapt their remuneration policies and practices to the new requirements. Taxand Spain summarises the key aspects of the new remuneration framework.

Irrespective of the different ways in which the Directive has been transposed in different EU countries, its approval, together with the publishing of the CEBS guide, has led European financial institutions to adapt their remuneration policies to comply with certain common aspects required by the Directive.

These aspects are:

  1. Identification of the group of employees and executives affected by the Directive.
    The principles governing the remuneration policy of credit institutions will apply to those staff members whose professional activities can have a material impact on the institution's risk profile.

    Although the Directive specifically includes senior management within that group, and these are employees who should not be particularly difficult to identify, it also refers to employees engaged in other functions, such as those who take risks ("risk takers"). Also included are employees who perform control functions, and those who receive overall remuneration that places them in the same remuneration bracket as senior executives and risk takers - it is not easy to determine if they actually have an influence on the risk profile of the financial institution.
  2. Payment of a significant portion of variable remuneration, at least 50%, in shares or capital instruments

    The reference to "capital instruments" as an alternative to paying in shares seems to have a twofold aim; to facilitate compliance with this legislation of financial institutions that do not issue shares or whose shares are not admitted for trading on a secondary market; and to treat as awards of shares certain systems for participating in capital that are based on an increase in the value of the institution (e.g. "stock appreciation rights" or "phantom schemes").
  3. Deferral or a portion of variable remuneration

    Deferral of payment of part of a variable remuneration component, in a percentage ranging from 40% to 60% for a period of three to five years, is one of the questions which together with the payment of a portion of variable remuneration in shares, has most directly affected financial institutions' remuneration policies.
  4. Inclusions of malus and clawback clauses with respect to variable remuneration

    "Malus clauses" would make it possible, in certain circumstances, to reduce the amount of the pre-established remuneration outstanding, whereas "clawback clauses" would permit an institution to claim a portion of the deferred remuneration after it has been paid.
  5. Review of the metrics used to determine variable remuneration

    According to CEBS guidelines, indicators commonly used in long term variable schemes such as Total Shareholder Return ("TSR") or operating efficiency indicators ("Earnings Per Share") are not adequate to capture the risk taken on by the employees and executives affected by the Directive.

    CEBS recommends employers resort to other metrics that take a long term view, including risk related adjustments and economic efficiency measures.

    Some remuneration systems approved after the Directive have incorporated metrics such as risk-adjusted return on capital ("RAROC"), return on risk-adjusted capital ("RORAC") or economic profit.
  6. Proportionality between fixed and variable remuneration components

    The Directive establishes that fixed remuneration should be sufficiently high to remunerate the level of responsibility discharged, and that there should be an appropriate balance between fixed and variable remuneration.

Taxand's Take

It is especially necessary for all companies, regardless of their sector of activity, to perform an internal review of their existing management team remuneration policies, on the basis of any of the following questions:
  1. Where is our company headed with its current management team remuneration policy?
  2. On what objectives is the variable remuneration we pay to our key employees based?

In some cases, companies will find that their executive remuneration systems give an answer that is quite different from the company's strategic objectives.

The implementation of a medium and long-term capital-based incentive system may have a direct impact on two of the main problems of executive remuneration that have been brought to light by the current financial crisis: the focus on short-term profits of some remuneration systems, and the consequent scant alignment between the interests of shareholders, who have seen their investment compromised by executive action, and the objectives of executives, who in many cases have received significant remuneration.

These kinds of systems, if they are designed effectively would make it possible to link a portion of executive remuneration to obtaining value for shareholders in a sustainable manner over time. Executives would only be rewarded if the shareholders consider the company to be a profitable and safe market investment.

Your Taxand contact for further queries is:
Jamie Sol
T. +34 91 514 52 00

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