The bulk of a new type of allowance paid to bankers are in breach of the European Union's bonus cap and must be changed by the end of the year, the EU banking watchdog said on Wednesday, raising the prospect that banks will have to bump up basic pay or risk losing top staff.
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The bonus cannot be more than basic pay, or twice that amount with shareholder approval.
With banks having to be bailed out by taxpayers in the financial crisis, the world's toughest curb on banker pay aims to stop reckless bankers who hope that taking bigger risks equates to fatter rewards.
Wednesday's ruling from the European Banking Authority (EBA) will hit up to a few thousand bankers, mainly in London where regulators gave allowances the green light as the British government challenges the cap in the EU's top court.
Lawyers already predict a scramble to revise pay contracts to meet the deadline as the bonus cap comes into practical effect on handouts due in early 2015.
Under the EU law, remuneration must either be classified as variable and part of a bonus, or fixed. Banks say allowances come under fixed pay and are essential to retaining staff in the face of global competition from New York and Singapore.
EU policymakers argued they are simply a ploy to circumvent the bonus cap and asked the EBA to investigate.
The EBA report said the vast majority of the new role-based allowances are being wrongly classified as part of fixed pay.
It found 39 banks that cover the bulk of European banking paying "role based" or "market value" allowances, with the vast majority of role-based allowances breaching EU law.
For a role-based allowance to be part of fixed pay, it must be permanent for that specific job, pre-determined, non-discretionary, non-revocable and transparent to all staff.
In "most cases", however, this type of allowance was discretionary and affected the bonus cap, EBA said.
EBA gave the nod to routine allowances for specific purposes such as childcare, regular pension contributions, travel and health insurance.
Additionally, "market value" allowances paid to every employee working outside their home country to cover higher costs were also acceptable.
"Whereas findings in the report showed that most of the allowances, which were the subject of the EBA investigation, did not fulfil the conditions for being classified as fixed remuneration, namely with respect to their discretionary nature, which allows institutions to adjust or withdraw them unilaterally, without any justification," EBA added.
These role based allowances were found not to be included in basic pay, were not pensionable, often granted for only a year and with a written acceptance they can be withdrawn.
EBA said banks using allowances that don't comply must rewrite their remuneration policies by Dec. 31 so that the allowances are properly classified in time for bonus payouts due in early 2015.
National regulators should also take "all the appropriate supervisory actions" to make sure allowances comply with EBA guidance, the watchdog said.
EBA's board, on which Britain's Bank of England sits, is thought to have unanimously backed the report's findings and recommendations.