The changes set out by The Bank of England yesterday are part of proposals to introduce a tough new regime for lenders in the wake of the financial crisis.
Newly confirmed rules - which will come into force in January in time for the next round of City bonuses - will mean pay-outs can be clawed back up to seven years after they are handed out - which could be extended by a further three years for senior executives.
These rules, finalised by the Bank’s Prudential Regulation Authority (PRA), will not apply retrospectively, partly for fear this could result in legal action.
But Mark Littlewood, director-general of the Institute of Economic Affairs, a free market think-tank, said the plans could harm the country’s banking industry.
He said: “If the Bank of England are serious about fostering an ethical culture in the UK banking sector, a clawback scheme on bonuses is entirely the wrong way to go about it.
“The financial industry is already one of the most heavily regulated in the economy.
“If we persist with this upward trend of regulation, we risk undermining the City and pushing both talent and investment overseas.”
The proposals from the PRA and City watchdog the Financial Conduct Authority (FCA) would also beef up firms’ ability to recover bonuses for bosses even if already paid out “if risk management or conduct failings come to light at a later date”.
The plans have been welcomed by both Business Secretary Vince Cable and Shadow chancellor Ed Balls.
A Treasury spokesman said: “This Government has been clear that banks must act responsibly in setting their pay policies, and we have consistently taken robust action to tackle inappropriate remuneration.”
This latest announcement comes in the wake of recommendations last year by the Parliamentary Commission for Banking Standards.
It follows the financial crisis and a series of scandals in recent years, such as the mis-selling of payment protection insurance (PPI), which has already cost the banking industry more than £20 billion in compensation costs so far.
Bonus rules have been strengthened since the credit crunch struck, with bank payouts deferred for three to five years and made largely in shares.
But there has been frustration that millions of pounds in bonuses paid out in the run-up to the banking meltdown are untouchable.
This latest consultation sets out plans to extend bonus deferrals to seven years for senior managers, but stops short of a longer nine-to-eleven year period that might reflect the impact of strategic decisions they have made as this could damage incentives.
Further proposals look at how to shut down the loophole of bankers evading reductions in pending bonuses by changing employer.
The plans also strengthen the existing presumption against discretionary payments from bailed-out banks.
Final rules based on the consultation will be published by the FCA and PRA in early 2015.
FCA chief executive Martin Wheatley said: “How a firm conducts its business and treats its customers must be at the heart of how it operates.
“This has to start at the top.
“Today’s consultations mark a fundamental change in the regulators’ ability to hold individuals to account, which is what the public expects of us.”