How should financial institutions receiving taxpayer funds compensate their employees?

That question is igniting a heated debate in Washington and on Wall Street, which will soon reverberate around the world. The viewpoint that's gaining momentum right now could make it difficult for banks and entities like American International Group to ever re-emerge as viable institutions with no government ties.

The viewpoint was expressed most clearly by New York State Attorney General Andrew Cuomo. In a letter to directors of nine large banks receiving funds from the U.S. Treasury Department under the Troubled Asset Relief Program, Cuomo warned not to enlarge their firms' bonus pools after signing on to the relief program. He demanded - with a one-week deadline - details of how each firm totes up and divvies up bonus amounts.

Cuomo's wording leaves no doubt he's interested in all bonuses, not just those of top executives who fall under the scope of TARP's compensation provisions. In fact, he pointedly asked each bank to provide "a description" of the bonuses awarded to employees whose compensation exceeded $250,000 in either 2007 or 2006.

Taxpayers Become Activist Shareholders

Cuomo's letter, dated Oct. 29, goes on to say: "Now that the American taxpayer has provided substantial funds to your firm, the preservation of those funds is a vital obligation of your company. Taxpayers are in many ways, now like shareholders of your company, and your firm has a responsibility to them."

Taxpayer are now like shareholders of your company. Indeed they are. Therefore it's no surprise to see taxpayers' elected representatives demand "their" management show accountability for major expenditures past and present. Rep. Barney Frank (D-Mass.), who heads the powerful House Financial Services Committee, actually called for a "moratorium" on bonuses among all financial institutions, on grounds that bonuses in their current form motivate employees to make overly risky bets. Rep. Henry Waxman (D-Calif.), chairman of the House Committee on Oversight and Government Reform, expressed displeasure that the nine largest banks' accrued compensation expenses through September are holding near last year's levels, instead of shrinking.

These officials evidently feel banks, once brought under the public umbrella, should be run not like businesses but like public agencies, where salaries are set by published charts rather than managers' discretion - and where bonuses don't exist. A great many voters seem to share that view. It all sounds fair - even logical. Until, that is, you stop to ponder what's the exit strategy. If every banker's pay is effectively subject to congressional review, who will want to work for banks? Individuals who seek public service careers, and no one else. The longer it goes on, the more the industry's ranks will fill up with such individuals. After five years, it might no longer be practical to return a partially nationalized bank to the rough-and-tumble of life in the private sector.

A Perverse Outcome

If Cuomo, Frank, Waxman et al succeed in imposing a radically different compensation model - eliminating substantial bonuses for most employees, slashing total pay, and subjecting individual and aggregate compensation decisions to high levels of transparency and public oversight typically associated with public services such as school systems - the predictable outcome will be to transform Wall Street into a subsidiary of Washington. Instead of limiting taxpayers' exposure to financial-sector troubles, the reforms would have the perverse effect of locking in that exposure for a decade or more.

Many in government might like nothing better than seeing Fannie Mae, Freddie Mac, AIG, and a large swath of the banking industry not merely regulated, but under full or partial government control - forever. Corporate chieftans have a well-known fondness for empire-building. Does anyone seriously believe that politicians are any different?