New rules on capital requirements for banks and a cap on bonuses for bankers are the results of negotiations between the European Council and European Parliament which were concluded with a deal late on June 29 2010.

The European Parliament said in a media statement on June 30 that it was confident that the agreement delivers tough and effective rules that will cover all bonuses awarded or paid from 2011 onwards. It will be the first cap on how bankers are paid worldwide.

"Two years on from the global financial crisis, these tough new rules on bonuses will transform the bonus culture and end incentives for excessive risk taking. A high-risk and short-term bonus culture wrought havoc with the global economy and taxpayers paid the price. The public want banks to prioritise stability and lending over their own pay and perks. In the last two years the banks have failed to reform, and we are now doing the job for them, " said Arlene McCarthy, rapporteur in charge of the negotiations for the European Parliament.

Together these new rules will lay the foundations for a safe and sound capital base and a responsible pay and bonus policy, so that taxpayers do not face the risk of bailing out the banks once again, according to the European Parliament's media statement. 

A different bonus culture

This new EU wide law will transform the bonus culture and end incentives for excessive risk taking, the statement said. These incentives for chasing short term bonuses over the long term health of the financial system played a key role in the crisis. The new rules mean reward is linked to long term performance. 

Cash bonuses will be capped at 30 per cent of the total bonus and to 20 per cent for particularly large bonuses.  In place of upfront cash, a large part of any bonus must be deferred and can be recovered if investments do not perform as expected.  Moreover, at least 50 per cent of all income not deferred would be paid as "contingent capital" (funds to be called upon first in case of bank difficulties).

Bonuses will also have to be capped to salary.  Each bank will have to establish limits on bonuses related to salaries, on the basis of EU wide guidelines, to help bring down 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 underlying strength of the bank. This will avoid similar situations experienced recently of bankers walking away from disaster with an enormous cash pension pot.

Harsher treatment for bailed out banks

To address moral hazard, the law will introduce special measures for bailed out banks and it will restrain the overall amounts paid in bonuses, encouraging bankers to prioritise a stronger capital base and lending to the real economy over their own pay and perks.  The rules will also require that the repayment of taxpayers is the priority.

Capital requirements for stable banks

New capital rules for re-securitisations and the trading book will ensure banks are properly covering the risks they are running on their trading activity, including for types of investments like mortgage backed securities that were central to the crisis.

Next steps

Following June 30 2010 official agreement from the European Council, the text will now be submitted to the European Parliament's plenary for approval.  Once this is finalised, the rules are expected to take effect in January 2011 for the bonus provisions and January 2012 for the capital requirements provisions.