Recommendation on remuneration in financial services sector - briefing

29 April 2009
by eub2 -- last modified 29 April 2009

The European Commission has adopted a Recommendation on remuneration in the financial services sector. It recommends that EU Member States ensure that financial institutions have remuneration policies for risk-taking staff that are consistent with and promote sound and effective risk-management. The Recommendation sets out guidelines on the structure of pay, on the process of design and implementation of remuneration policies and on the role of supervisory authorities in the review of remuneration policies of financial institutions. The Commission has also adopted a Recommendation on directors' pay.

Why has the European Commission decided to adopt a Recommendation, which is not legally binding, and not proposed a Directive?

The objective of the Commission in proposing new principles on sound remuneration policies in the financial services sector is to ensure that remuneration policies are consistent with effective and sound risk management. A Recommendation allows the Commission to adopt principles which are sufficiently detailed so as to provide some guidance on the structure of remuneration policies, and thus to react rapidly and efficiently in the context of the current crisis. The principles do not touch on the level of pay from the social and labour law perspective, as they are not intended to prescribe particular levels or designs of individual remuneration. A Recommendation allows the Commission to provide a framework for setting out principles or best practices. It enables the Commission to adopt general principles applicable to the entire financial services industry across a range of different financial institutions which differ in goals, activities and culture. The measures to be taken by Member States following the Recommendation could be tailored to each particular sector of activities.

How does the Recommendation relate to the future legislative proposals announced in the Commission Communication of 4 March to the Spring European Council?

The Recommendation will be followed by legislation on the supervisory review of remuneration policies, as mentioned in the Commission Communication of 4 March to the Spring European Council. The legislative proposals should introduce a binding obligation for financial institutions to have in place sound remuneration policies, and should focus on the supervisory review and on the range of measures available to the supervisors in order to ensure that financial institutions comply with this requirement. In this context, the principles set out in the Recommendation will be highly relevant. They will provide guidance to financial institutions as to how this binding obligation could be met, and a framework for supervisors when assessing firms' remuneration structures.

In mid-June the Commission will address remuneration policy in banks and investment firms (this is where the clearest market failure has occurred on the basis of the evidence available to date) through the package of modifications of the Capital Requirements Directive. The legislative changes that will be proposed will bring remuneration policies and their link with risk management clearly within prudential oversight in the supervisory review process under that Directive. Credit institutions and investment firms will be legally obliged to have remuneration policies that are consistent with effective risk management, and supervisors will be able to take measures to address any failures by credit institutions and investment firms in this regard.

Why does the Recommendation not apply to fees and commissions?

The objective of the Recommendation is to introduce principles on remuneration policies within financial institutions in order to reduce perverse incentives and excessive risk-taking by individual staff. Fees and commissions paid to third parties fall outside the scope of this objective. Indeed, these fees and commissions could in some cases create perverse incentives for service providers, especially by encouraging them to maximise their own results and act against the client's interests. However, the compensation practices relating to such fees and commissions are already partially covered by special regimes, in particular the Markets in Financial Instruments Directive (2004/39/EC) and the Insurance Mediation Directive (2002/92/EC).

What categories of financial institutions are covered by the Recommendation?

The Recommendation applies to all actors in the financial services industry, regardless of the legal status of the financial institution. This includes credit institutions, investment firms, insurance and reinsurance undertakings, collective investment schemes, pension funds and other institutions with professional activities in the financial services industry. However, the Recommendation only applies to institutions who exercise activities of the financial sector on a professional basis. This excludes those institutions that perform such activities only occasionally or on an ancillary basis.

Why does the Recommendation cover only staff whose activities have material impact on the risk profile of the financial institution?

One of the main problems identified regarding the remuneration policy in the financial services sector was that remuneration policy was not sufficiently aligned with risk tolerance of the financial institutions. It induced excessive economic and financial risk-taking not only by key executives and senior management, but also on the lower level of the financial institution, such as sales and trading. Therefore, it is important that principles on sound remuneration policies should apply to those staff members who perform activities which have a material impact on the risk profile of the financial institution. Applying the same principles to staff whose functions do not have any impact on the risk profile of the financial institution is not necessary in order to achieve the objective and could result in an unjustified administrative burden for financial institutions.

Since this is a Recommendation, Member States are free to decide whether to implement it or not. What would the Commission do if a majority of Member States did not follow the main lines of the Recommendation?

Since this is a Recommendation, the Commission will not be able to open infringement proceedings against those Member States that do not implement it. The Commission nevertheless invites Member States to inform it by 31 December 2009 of what they are doing to promote the application of the Recommendation. That will allow the Commission to monitor closely the situation within the EU and to assess whether greater convergence of remuneration practices has been achieved, and to report on this basis to the Council and to the European Parliament.

Source: European Commission