By Huw Jones and Steve Slater LONDON (Reuters) - New types of allowance paid to bankers are nearly all in breach of the European Union's cap on bonuses 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.
The sight of bankers pocketing hefty sums at a time when many people are hit by pay freezes and high unemployment across Europe prompted the EU to cap the bonuses of bankers earning more than 500,000 euros ($630,000) a year.
Bonuses cannot be more than basic pay, or twice that amount if shareholders approve.
With banks having to be bailed out by taxpayers in the financial crisis, the world's toughest curb on bankers' pay aims to restrain the reckless who hope that bigger risks mean bigger rewards.
EU financial services chief Michel Barnier, who asked the European Banking Authority (EBA) to compile the report, said allowances sent a very bad signal to society that banks have not learnt from the financial crisis or adapted their cultures.
"Compliance with both the letter and the spirit of the law is a prerequisite to restore trust and stability in our banking system," Barnier said.
PwC, a consultancy, said the ruling was at the most severe end of industry expectations and that the vast majority of big banks in the EU will need to change their pay policies.
Sources at UK banks said they would see how UK regulators apply the ruling, and it was unclear if bonuses covering 2014 performance and to be paid in 2015 are affected.
The EBA's board vote that ruled the allowances illegal and set a deadline for changes was not unanimous, the watchdog said.
"LEAST WORST"
The Bank of England, an EBA board member and whose Prudential Regulation Authority had endorsed the allowances as a "least worst" alternative to a cap, declined to say how it voted or whether it would apply the new EU guidance.
Barnier said that in principle bonus payments handed out next year will be affected, adding that the European Commission and the EBA will decide if enforcement action is needed.
Wednesday's ruling will mainly hit bankers in London, where regulators gave allowances the green light as the British government challenges the bonus 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 effect on handouts due in early 2015.
Barclays, HSBC and Standard Chartered have said they are among those paying allowances or planning to, and sources said most other major banks are too, including JPMorgan and Goldman Sachs. About 10,000 bankers receive the allowances, according to industry estimates.
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 retain 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 have called a spade a spade," said John Thanassoulis, professor of financial economics at Warwick University. "They have come down hard against this trick."
But he said banks would create more risks by increasing basic pay, leaving them potentially unable to cut costs quickly in a downturn.
Andrew Tyrie, chairman of the British parliament's Treasury Committee, which oversees the Treasury and the Bank of England, said the EU bonus cap was fundamentally flawed.
"It will encourage banks to increase fixed pay rather than embed incentive structures that improve standards," he said.
The British Bankers' Association, which represents UK and overseas banks, said any move that increased fixed costs and reduced pay flexibility was "counterintuitive," and Britain's Institute of Directors said the bonus cap was the wrong tool to reform bankers' pay.
"Encouraging banks to increase fixed pay, whether salary or one of these allowances, was clearly not the intention of the cap, and yet this is exactly what happened," said Oliver Parry, corporate governance adviser at the Institute of Directors.
WRONGLY CLASSIFIED
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.
The 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 fulfill 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.
The 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.
Jacqui Hatfield, a lawyer at ReedSmith, said the ruling clarifies that an allowance for a particular role and that cannot be changed or clawed back should still pass muster.
Some 14.4 billion pounds ($22.9 billion) was paid in bonuses in Britain's financial sector in the year to April 2014, up 3 percent from the year before but down from more than 18 billion pounds in 2007/08.
The average bonus per employee was 13,300 pounds ($21,250) in the financial sector last year, compared to 1,500 pounds($2,400) across the whole UK economy, the Office for National Statistics said.
(1 US dollar = 0.7904 euro)
(1 US dollar = 0.6283 British pound)
(Additional reporting by Carmel Crimmins in Dublin; Editing by Giles Elgood)