The economy may be leveling off, the stock market far from its March lows, and even real estate showing signs of life, but you can be sure that one aspect of the financial crisis is still heating up: Wall Street compensation.

Even now investment bankers, deal makers, traders and brokers are tallying their results and calculating their likely multimillion-dollar year-end bonuses. Given the stock market s breathtaking rise, the massive amount of debt issuance, and the surge in mergers and acquisitions, these bonuses are going to be big possibly topping the record-setting pace of 2007, when the stock market peaked.

What s different this time is that many of these bonuses will be paid to employees of banks that received money from the Troubled Asset Relief Program, which, in some cases, might not have survived without a taxpayer bailout. The fact that millions are going into the pockets of the very people who are perceived as having caused the crisis, and then having to be rescued by the government, outrages many. The summer s furor over $100 million due a top trader at Citigroup, a poster child for government assistance, is merely a taste of what lies ahead.

I, too, have been troubled by the huge bonuses being paid at money-losing firms. Who wouldn t be, excepting the bonus recipients themselves? Still, the issue is complex. Now that taxpayers own large chunks of institutions like AIG and Citigroup, we have to manage them to maximize a return on our very large investments. If that means paying top talent a competitive salary and bonus so they don t leave to work for a competitor, so be it. This is the conundrum: Financial firms may be losing billions and even on the brink of failure, yet their future depends on attracting and retaining talented bankers with lavish compensation.

A Failure in the Market

To me, this points to a fundamental failure in the market for banking talent. To be fair to Wall Street, it s not a problem unique to the financial sector. It s analogous to the market in Hollywood, where major stars are guaranteed lavish payouts, even percentages of gross revenue, no matter how badly a film fares at the box office. Hollywood studios get all kinds of tax benefits, but at least so far, none have been bailed out by the government. Maybe that s why people seem willing to tolerate lavish pay as one of the perks of stardom.

The reasons for the market s failure on Wall Street pay are many, but a fundamental one seems to be that (as in Hollywood) human talent is the only asset that really matters. Unlike plants or equipment, it can get up and walk away. Individual interests inevitably trump institutional interests.

As we ve learned from the financial crisis, when markets fail, government intervention is needed. The Obama administration, as part of its proposed regulatory reforms, is backing legislation aimed at eliminating conflicts of interest on compensation committees and giving shareholders a (nonbinding) say on pay packages. That s fine as far as it goes which isn t very far. Much as I would like to encourage shareholder democracy, micromanaging compensation isn t the kind of task that shareholders are equipped to perform. Congressman Barney Frank has proposed unspecified curbs on pay in the financial sector, the details of which would be worked out by regulators over the next nine months.

Despite the recent outcry over Goldman Sachs s strong earnings and the accompanying likelihood of big bonuses, I don t think most people begrudge big payouts when they reflect performance. Hedge-fund clients have willingly handed over 20 percent of the gains or more to managers who beat the market. The glaring problem that has surfaced in the financial crisis, however, is that Wall Street pay too often is not linked to performance, certainly not to long-term performance. The annual bonus calculation, linked only to a single year s results, encourages excessive risk taking. One big payout is worth risking years of losses, since bonuses don t go below zero. Stock options, meant to align compensation with shareholder returns, suffer from a similar problem. They cost the recipient little or nothing, yet they promise unlimited returns, grossly skewing incentives toward short-term gains.

Steps Toward Reform

I believe a few relatively simple reforms would address these problems, better aligning employee compensation with performance and discouraging excessive risk taking with someone else s money.

Ban guaranteed bonuses. The very idea is an oxymoron. A bonus, by definition, should be tied to performance. Unfortunately, guarantees have become the weapon of choice in recruiting and retaining talent. Since Wall Street seems incapable of reining in such destructive competition, restraint will have to be imposed on it.

Tie bonuses to multiyear performance. Annual bonuses should be calculated based on a rolling multiyear average, say four years. While some have talked about claw back provisions, in which those responsible for losses would have to pay back some or all of their previous bonuses, I don t think that s feasible. (It s amazing how fast some people manage to spend their bonuses.) With a multiyear average, losing years would offset years with big gains. It would also be an incentive for talent to stick around, since bonuses would vest only at the end of the rolling period.

Require employees to own stock not options purchased with their own money at no more than a 15 percent discount to the prevailing market price. Compensation could also be in stock, but only in lieu of, not in addition to, cash payments. This is similar to requirements many publicly traded companies impose on their directors; it should align employee interests with those of shareholders and with the interests of the company. Presumably, traders would think twice before making bets that might sink the firm, if their well-being turned on the results for the firm as a whole and not just their own trades.

Those are easy-to-implement steps. And now that I think about it, why stop with banks and financial services? These principles could be applied to corporate leaders across the board. They would curb excesses while avoiding caps on pay and preserving incentives to succeed. One of America s greatest strengths is that it s still a land of opportunity. I m proud of the fact that this country mints new billionaires every year. But let s make sure they ve earned their money, rather than plundered it from shareholders and taxpayers.