Don't Pay Bankers To Bet Boldly? Don't Laugh...

Global bank leaders meeting in Rio de Janeiro this week are discussing the unthinkable: overhauling industry-wide compensation practices in an effort to shore up risk management.

The Institute of International Finance (IIF), a global association of banks, is seeking to create a code of best practices "which would discourage banks from giving incentives to traders to take excessively risky bets and from failing to censure them if these turn sour," according to Wednesday's Financial Times.

The emerging compensation code is part of a string of reforms the group is hashing out in a bid to convince policymakers that bankers are capable of regulating themselves - and thereby head off the threat of onerous government regulation sparked by public anger over the ongoing credit crisis.

Proposals to change the industry's standard compensation structure include setting and paying bonuses only after the "the full effect of bankers' strategy is clear to prevent them benefiting from short-term high-risk bets that subsequently turn sour" and making participants in losing trades recoup losses before they can be eligible for a subsequent bonus. (That's akin to the "high-water mark" hedge fund managers must meet before earning new performance fees after they've lost money for clients.)

Bank leaders mulling reforms are mindful that some areas where pay rose fastest in recent years - such as complex credit - are the same ones at the heart of the current crisis. Although fixed-income bonuses were slashed last year and numerous executives were forced out of their jobs, compensation continues to be dominated by individual traders or a group's current reported profit, a structure that appears to promote "après moi, le deluge" behavior by both traders and bank executives.

The FT calls compensation the thorniest of several issues that may go into the IIF's "best practices" code. In fact, the issue is so controversial it might prevent the group from adopting a wide-ranging reform plan that was expected to be finalized this week. Other guidelines deal with the credit ratings process, methods for valuing complex securities, risk management, liquidity operations, underwriting standards and the handling of off-balance-sheet vehicles.

Of course, Wall Street's dependence on bonuses as a competitive weapon argues against any major change to pay practices. But some of the industry's heaviest hitters seem to be squarely behind the IIF reform proposal. They include Josef Ackermann, the chairman of both Deutsche Bank and the IIF; Charles Dallara, head of the IIF and a former U.S. regulator; and central banker Philipp Hildebrand, vice-chairman of the Swiss National Bank.

"At present, compensation incentives are asymmetric . . . This encourages employees to take excessive risks," Hildebrand told the FT.