MEPs Approve Tougher Banking Rules

by Ulrika Lomas, for LawAndTax-News.com, Brussels

09 July 2010

The European Parliament (EP) has approved a law imposing strict rules on bankers’ bonuses, and on the capital reserves that banks must hold against risks from their trading activities and exposure to complex securities, whilst also proposing a European-wide financial crisis management framework.

With regard to remuneration, the Capital Requirements Directive (CRD) primarily aims at giving effect at European Union (EU) level to the Financial Stability Board principles and standards on compensation agreed by G20 leaders.

It therefore pursues three objectives: to impose a binding obligation on banks to have remuneration practices that are consistent with and promote sound and effective risk management; to bring remuneration policies within the scope of the supervisory review under the CRD; and to ensure that supervisors may also impose financial or non-financial penalties (including fines) against firms that fail to comply with the obligation.

Upfront cash bonuses will be capped at 30% of the total bonus, and at 20% for particularly large bonuses. Between 40% and 60% of any bonus must be deferred for at least three years and can be recovered if investments do not perform as expected. Moreover, at least 50% of the total bonus will be paid as "contingent capital" (funds to be called upon first in case of bank difficulties) and shares.

Bonuses will also have to be capped as a proportion of salary. Each bank will have to establish limits on bonuses related to salaries, on the basis of EU guidelines, to help bring down what is called “the overall, disproportionate, role played by bonuses in the financial sector”.

Finally, bonus-like pensions will also be covered. Exceptional pension payments must be held back in instruments such as contingent capital that link their final value to the overall strength of the bank. It was felt that this would avoid situations, similar to those experienced recently, in which some bankers retired with substantial pensions unaffected by the crisis their bank was facing.

The law will introduce special measures for bailed-out banks, and will restrain the overall amounts paid by them in bonuses, encouraging bankers to prioritize a stronger capital base. In particular, the rules provide that no bonuses should be paid to the directors of such an institution, unless this is duly justified.

The European Internal Markets and Services Commissioner, Michel Barnier, said: “The requirements on pay and bonuses send a strong political message: there will be no return to business as usual. The EU is leading the way in curbing unsound remuneration practices in banks. Banks will need to change radically their practices and the mentality that have led in many cases to excessive risk-taking and contributed to the financial crisis.”

The CRD will also strengthen banks' capital positions and reform the capital rules for their trading books and for securitizations.

It is intended that new capital rules for securitizations and the trading book will ensure banks properly assess and cover the risks to ensure that their assessment takes full account of the potential losses in the kind of stressed conditions experienced during the recent crisis, including for types of investments such as mortgage-backed securities.

“The tougher capital requirements for banks' trading books and their investments in securitizations - the kind of highly complex products that have caused huge losses for banks - will ensure that banks hold significantly more capital to cover their risks,” Michel Barnier added. “This will make the sector as whole better able to resist stress."

Studies have shown that the rules are expected to lead to banks having to hold three to four times more capital against their trading risk than they do at present.

Following the EP vote of approval, the European Council will rubber-stamp the law, possibly on July 13. The rules on bonus provisions will then take effect in January 2011 and those on capital requirements provisions no later than December 31, 2011.

The EP has also adopted a resolution which proposes that a EU special system should be set up to ensure that any future financial crises are handled and resolved earlier under a cross-border crisis management framework which, it said, should avoid the “rushed, weekend bank bail-outs costing the taxpayer hundreds of billions of euros”. Given the growing size, complexity and interconnectedness of banks, it has decided that such a system must be established at European level.

Therefore, MEPs urged the European Commission (EC) to submit by the end of this year draft legislation relating to the management of cross-border crises in the banking sector. In particular, they called for an EU crisis-management framework, an EU financial stability fund and a resolution unit within the future European Banking Authority (EBA) to deal with insolvencies of cross-border systemic banks.

"Risks cannot and should not be eliminated from the market but we do require regulation which will make risks more transparent," said MEP Elisa Ferreira, who drafted the bill. "It is not our job to prevent banks going bankrupt but it is our job to ensure that the way in which they are liquidated or reorganized is done in an orderly fashion, and also to limit collateral effects elsewhere in the system to ensure that it is not the taxpayer who picks up the tab".

It is hoped that the crisis management framework proposed in the resolution would, in the event of a crisis, preserve financial stability, minimize the cost to taxpayers, preserve basic banking services and protect depositors.

It would provide a common minimum set of rules, foster the convergence of national resolution and insolvency laws, and ultimately establish an EU resolution and insolvency regime. It would grant more crisis management powers to supervisory authorities, including the powers to wind up a bank or impose a total or partial sale. Considerable coordination powers would be vested in the EBA.

A "Risk Dashboard," based on a set of indicators to be designed by the EC, is also proposed, with a view to rating the risk levels of individual banks and providing early warning of possible instability. Each bank would be required to have its own "resolution plan" which would detail the steps to be taken should it run into difficulties, so as to avoid rushed decisions.

Barnier welcomed the EP's suggestions as a "very credible toolbox", and assured MEPs that the EC would reflect these suggestions in the consultation paper it is to launch in October, as well as in the legislation to be submitted next year.

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