Heads we win, tails we don’t lose. That’s the rule for Wall Street employees. The financial market crisis is still unraveling. Shareholders have seen a steep erosion in their wealth. But Wall Street’s top five firms are set to distribute $38 billion in bonuses this year, up from $36 billion last year. Bonuses in a year as bad as this one? Elsewhere, that would regarded as a cruel joke. Not on Wall Street.

Firms such as Goldman Sachs that have done well through intelligent hedging of risks have every reason to reward their employees. Just under a half of this year’s bonus will likely be accounted for by Goldman. According to one estimate, the payout at Goldman will be large enough to finance the acquisition of another top five player, Bear Stearns, whose stock has been battered in recent months.

At other firms, bonuses will be justified in relation to divisional performance, no matter that the firm as a whole has not done well. Investment banks such as Merrill Lynch may have run up huge losses due to exposures to subprime mortgages but that is the problem of the divisions concerned. The other divisions will insist on being rewarded. On Wall Street, it is understood that total pay has a large variable component and this helps keep base pay down. The variable component has largely to do with individual performance.

If an individual does well, he or she would have to be rewarded even if the firm does not do well. Wall Street would argue that without variable pay that matches individual performance, base pay would have to be uniformly higher in order to retain bright people. A higher base pay would reward non-performers along with those who perform. Shareholders would be even worse off in that situation.

There is another reason why Wall Street firms pay large bonuses even when the firm has not done well. Unlike in many manufacturing firms, divisional performance and, in many cases, individual performance are easily measurable. Traders’ profits are known. Revenues from IPO deals brought in by investment bankers are transparent. Fees related to mergers and acquisitions are obvious. Every individual is a profit centre.

In manufacturing firms, performance is the result of the concerted efforts of several groups. Hence isolating group and individual performance is more difficult. At an automobile company, if a new model of car fares well, does the credit go to product development or manufacturing or to marketing? If it goes to all these divisions, then in what proportion? This is hard to determine.

The investment banking compensation structure has not been without flaws. Until a few years ago, investment bankers were paid for making profits without the associated risks being taken into account. This is like a commercial banker being paid for a big increase in loans without factoring in non-performing assets that will show up down the road. With the development of models of risk-adjusted return on capital (Raroc), this problem has come to be addressed.

Where greater revenue arises from higher risks, the risks translate into higher allocation of capital for a given division. Investment bankers can then be rewarded in relation to return on capital. Bonuses do not have to do only with the numerator, profit. The denominator, the capital allocation for a given level of risk, also matters.

But a more fundamental problem remains. In activities that require the allocation of firm capital, investment bankers rake in huge rewards when they do well but are not adequately penalised when they inflict losses on the firm. At worst, they may get zero bonus or they may lose their jobs. But the firm does not recover money from them in proportion to the losses they have caused.

The classic example is that of a star trader at one of the top firms who was paid more than $100 million for extraordinary performance in a given year - his total pay exceeded that of the firm’s CEO by a wide margin. In the next year, he ran up a huge loss. He happened to be cruising around in his Lamborghini when word reached him that he was in for a pink slip. From his superbly equipped vehicle, he shot off two faxes. One, a letter of resignation intended to pre-empt his dismissal. Another, a covering letter and a CV to another firm seeking a position on the strength of his previous year’s performance.

Ideally, Wall Street firms should have a system that tracks employee performance over a business cycle. Only a portion of the rewards for a given year should be paid out. The rest should be credited to the employee’s account. Losses over the business cycle should require deductions from credits for profits made. Over, say, a five-year period, there will be credits and debits in the employee account. The balance must be paid out at the end of the period. Sounds fair, doesn’t it? But there is a fatal flaw in the scheme. Top management too would be subject to such a scheme and they would be the last people to want it.