Forget the European Union's bonus cap. Worse may be to come

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Like a busy cephalopod, the European Union's bonus capping law makers are putting their tentacles into places previously considered out of bounds. Asset management firms are the latest to be touched. Hedge fund managers could be next.

Sven Giegold, a German Green Member of the European Parliament (MEP) , has proposed that fund managers working at UCITS funds should have their bonuses capped as a proportion of salaries in much the same way as bankers. As reported yesterday, this implies a maximum cap on bonuses of 250% of salaries, with shareholder approval. The cap would be a step, “towards ending the gambler mentality in the investment fund sector,” said Giegold in support of its introduction.

While the investment banking bonus cap will definitely go ahead, Alex Beidas, a lawyer at Linklaters in London, said the asset management bonus cap is by no means a done deal. At this stage, it's simply a proposal from the European Economic and Monetary Affairs Committee. Before it can be introduced, Beidas said it would need to be agreed to by the European Commission and European Council and voted upon in the European Parliament. Changes are likely in the process.

Nevertheless, the sudden extension of the bonus cap to the asset management sector has come as a shock. It is also a sign: Now that they've started to regulate financial services pay, European law makers are inclined to continue.

Beidas said it's conceivable that the could re-open the Alternative Investment Fund Managers Directive (AIFMD) and impose the bonus cap on hedge fund managers too. As it stands, the AIFMD has been finalized and will be implemented on July 22nd 2013. But there is nothing to prevent amendments. The Capital Requirements Directive, which includes the bonus cap for bankers, has been amended four times -  with the cap only introduced on the fourth try. Hedge fund managers could yet have their bonuses capped as well, said Beidas.

Capping the ratio of high to low pay within organisations? 

Capping bonuses as a proportion of salaries may turn out to be innocuous, however, if the European Union adopts a proposal that has been suggested in Germany.

Spiegel reported last week that high salaries are becoming a contentious issue in the run up to this year's German election. Angela Merkel has spoken out against "exorbitant" executive pay. The Confederation of German Trade Unions (DGB) has called for salaries for executive board members to be capped as a proportion of the pay of the average employee. Michael Grosse-Brömer, a senior CDU politician from Angela Merkel's party, said conservatives would introduce a law before the summer recess to regulate manager salaries, Spiegel said.

It's conceivable - but unlikely - said one lawyer, that EU law makers could adopt DGB proposals and try imposing a future cap on pay within financial services organisations. Under such a cap, highly paid staff would only be able to earn a prescribed amount relative to the pay of the average employee.

The only stop on the EU's salary-setting power is Article 153, Paragraph 5 of the Lisbon Treaty, which states that the European Union has no ability to set pay in member states. However Stephen Mavroghenis, a partner at law firm Shearman & Sterling in Brussels, said EU lawmakers have proven adept at interpreting legal bases liberally. "The EU has no powers to set pay, but with the bonus cap they would argue that they are simply setting a ratio," he said. Challenging EU laws requires a submission to the European Court of Justice, which Mavroghenis said often sides with its law makers, meaning there is no guarantee that a challenge would be worthwhile or effective.

Losing the City of London's blocking minority 

The European Parliament's attempts to cap pay and bonuses in financial services are not the only threats to the City of London.

Christopher Howarth, senior political analyst at think tank Open Europe, said there are other dangers on the horizon in the form of the burgeoning power of the Frankfurt-based European Central Bank and the City-based European Banking Authority.

The European Banking Authority (EBA) is responsible for ensuring banks across Europe adhere to a common set of regulations. Under standard European voting rules, Howarth said the 27 Eurozone members would be able to use majority voting rules to control the edicts of the EBA and to potentially create rules that would be inimical to the City of London. However, the British government negotiated a system late last year whereby the ten non-Eurozone countries can vote between themselves on the EBA's rules, and block them if a non-eurozone majority objects.

This will protect the City from European Banking Authority regulation for the time being. Long term, however, Howarth points out that all EU members except the UK and Denmark are legally obliged to join the Eurozone. Once there are fewer than four non-Eurozone countries, their ability to block EBA regulations will lapse. At this point, Howarth said that it is feared that the EBA could introduce regulations that favour the financial centres of Frankfurt or Paris. Eurozone members have a history of favouring their own financial centres. In 2011, they tried to require that counterparties on euro trades be based in the eurozone, for example.

At the same time, the European Central Bank is becoming the single regulator for the biggest banks across the eurozone. This is strengthening the position of Frankfurt. "Decisions regarding financial services should be taken at a European level, but there is a danger that the ECB will become the default decision maker for the Eurozone countries, which are in the majority," said Hogarth. "There's a risk in future of the UK being left out."

UK politicians were said to be in shock over their isolation on the bonus cap. However, the floodgates are now open. The bonus cap is just the start.

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