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EU Regulators Seek to Police Use of CoCos in Banker Bonuses

Banks in the European Union face limits on how they can use securities such as contingent convertible bonds in bonus awards, as regulators seek to crack down on any attempts by lenders to avoid the full force of EU pay curbs.

The European Banking Authority published draft rules that would prevent banks from offering staff dividends on contingent capital instruments, such as CoCo bonds, that are out of step with those available to outside investors, the agency said in an e-mailed statement today. The measures would also require holders of the securities to face a real risk of losses if the bank’s performance plunges.

Securities issued as part of bonus awards “should take account of the institutions’ long-term interests and incentivize prudent risk-taking of staff,” the EBA said. “In this respect, these instruments must have a sufficient maturity to cater for deferral and retention arrangements.”

The EU this year bolstered its banker pay rules, already among the toughest in the world, to include a ban on bonuses more than twice as large as salaries. The updated law, set to take effect from January, gives banks more scope to use CoCos and other contingent capital to meet an existing EU requirement that at least half of a bonus award must be in shares or other non-cash instruments.

Nose Dive

CoCos are a form of fixed-income security that automatically converts into ordinary shares if a bank’s capital falls through a pre-determined floor. This type of bond -- along with other contingent capital instruments such as debt whose principal can be written down if a bank’s capital nose dives -- can mimic the clawback rules applied to cash bonus awards, by ensuring that bankers can face losses if the company’s performance turns out less strong than expected.

Banks have already taken nascent steps to use contingent capital instruments in pay packages. Switzerland’s UBS AG (UBSN) paid out 500 million francs ($537 million) of its 2012 bonus pool in bonds that can be written off if the firm gets into financial difficulties. This follows a similar move by Barclays Plc (BARC) when it deferred part of its 2010 bonus pool for senior employees over three years under a plan that pays only if the core Tier 1 ratio, a measure of financial strength, is at least 7 percent.

The EU legislation requires the EBA to define rules of the road to prevent such instruments being used in a way that undermines the bonus curbs.

Contingent Capital

The EBA guidance may spur the use the contingent capital in pay awards, as banks now have a clearer idea of what is permissible, Alex Beidas, an employee-incentives specialist at law firm Linklaters LLP, said in an e-mail.

“Although shares are likely to remain a popular method of paying staff, we are now likely to see more diversification including a move to offering employees debt which is written down or converted to equity in the event of a crisis,” she said.

The EBA’s “concentration on limiting bonus or performance-based remuneration raises the likelihood of both higher base salaries and yet more inventive ways to pay key staff,” Richard Reid, a researcher at the University of Dundee in Scotland, said in an e-mail. “Neither of these is a good thing from the perspective of stability.”

Outside Investors

The draft EBA rules include minimum capital levels at which writedowns, or conversions of the debt into equity, must happen, in order to ensure that the risk of losses is real.

They also stipulate that banks must sell at least 60 percent of a particular security to outside investors, or face caps on the dividends they can offer when the security is used in staff-pay packages. The cap would be set at 6 percentage points above a key EU benchmark for measuring annual inflation.

The use of contingent capital in pay awards “should not create undue advantages for staff, which could be understood as a circumvention” of the EU banker bonus rules, the EBA said.

EU rules cover categories of staff identified by the bloc’s regulations as material risk takers.

The EBA said it would seek views on the plans until Oct. 29, and hold a hearing on Oct. 3.

To contact the reporter on this story: Jim Brunsden in Brussels at jbrunsden@bloomberg.net

To contact the editor responsible for this story: Anthony Aarons at aaarons@bloomberg.net

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