Simmering row over bankers’ pay erupts between E.U. and U.K. by Geoffrey Smith @FortuneMagazine October 17, 2014, 7:15 AM EDT E-mail Tweet Facebook Google Plus Linkedin Share icons It isn’t often you see a banking regulator getting worked up about the right of banks to pay bonuses, but it’s becoming an increasingly sore point in the City of London, Europe’s biggest financial center. A long-simmering conflict has erupted into open warfare this week between the U.K., which thinks it has done enough to bring the culture of bankers’ pay under control since the financial crisis, and the E.U., whose functionaries still see it as being in thrall to a financial lobby that can’t be trusted to regulate itself. The dispute dates back to 2011, when the European Parliament mischievously introduced provisions to cap bankers’ bonuses into a draft law that was primarily concerned with implementing new global agreements on raising bank capital levels. After intense resistance from the City, that law made it on to the statute books at the start of the year. As a result, bonuses are limited to 100% of base salary in normal cases and to 200% if shareholders approve. Before the crisis, bonuses eight or nine times basic pay were common. Since the law came into force, City-base banks have been trying to get round it by paying selected staff “allowances” instead, based on their rank and function. But in an opinion earlier this week, the European Banking Authority, which dots the i’s and crosses the t’s on the fine print of the E.U.’s bank rules, ruled such allowances illegal (mainly because they can be withdrawn at the bank’s discretion) and told national regulators to clamp down on them. The Brits are now boiling mad. “Let me be blunt, the bonus cap is the wrong policy, the debate around it is misguided, and the best thing I can say about allowances is that they are a response to a bad policy,” the U.K.’s top banking regulator, Andrew Bailey, said in a speech to a sympathetic London audience Thursday night. Bailey is head of the Prudential Regulatory Authority, the arm of the Bank of England that supervises individual banks. One of Bailey’s biggest beefs with the new rules is that they ignore law and regulations that the U.K. has itself put in place since the crisis to rein in the excesses of bonus culture. Those rules still enshrine the importance of pay reflecting performance but ensure that a much greater part of variable pay is vested far into the future, and paid in the form of securities whose value would be wiped out if the bank needed recapitalization, as happened after 2008. That reduces for trading desks and others to run high-risk strategies for the sake of maximizing short-term profits and bonus pools. In a more recent change, the U.K. is also making it much easier for senior staff managers to be held criminally accountable for recklessness in future. But unhappiness with the E.U.’s rules goes way beyond the technocrats’ level. It’s a political issue that will be at the heart of next year’s elections. For a Conservative-led government, which is under huge pressure from the anti-European U.K. Independence Party, to be outvoted by Brussels on an issue vital to the economy’s most important sector is a major embarrassment, proof to Euroskeptics that it’s no longer in the U.K.’s interest to stay in the E.U. at all. The irony is that, for all its disenchantment with Europe, the vast majority of the British population outside London and its commuter belt wholeheartedly side with the E.U. in seeing an irresponsible City bonus culture as one of the main causes of the crisis.