John Carney has written two good posts (here and here) this weekend on Wall Street compensation. In the first he pointed out that compensation policies really weren’t to blame for the crash and in the second argues that any attempts to reduce compensation will likely result in perverse and unintended results.

I am inclined to agree with the gist of his arguments, however, I think that there is another way to attack this beast that leaves it up to the owners and employees of these firms to sort out the issues.

Quite clearly, giant financial institutions that pose huge systemic risks are not going to go away and they are going to continue to be too big to fail. We might as well stipulate to that fact up front. These firms have too much political power to be dismantled and the dismantling would likely take decades even if we had the will to try. Therefore, the best way for society to deal with the threat is to require them to maintain a cushion against loss that is sufficiently large so as to minimize the overall cost of any future bailouts.

The easiest way to do this is to impose very large capital requirements. Since we should have by now convinced ourselves that mathematical models of risk are inherently untrustworthy, the capital requirements need to be based very simply on size. The bigger you are the more capital you’re going to have to maintain.

How much? I don’t have a magic answer but I think our recent experience can point towards some numbers. How much did we have to pony up to rescue Citi for example, to get it back into survivor mode. Take that as your base and apply it to the biggest firms. They’ll whine about not being Citi and that they shouldn’t be painted with the same brush but that’s the penalty for being big. We know we can’t predict or prevent the next Citi but we can protect ourselves.

So what does this have to do with compensation? Well, first it properly removes the discussion from the public realm where it does not belong and leaves it up to the employees and shareholders of the banks to hash out. With larger capital requirements, returns are naturally going to be reduced and the owners and employees of each bank will have to negotiate an appropriate split of the profits. Most likely, the shareholders are going to demand a larger than fifty percent piece of the pie but that ceases to be a public policy issue.

Our objective should be to ensure the survival of the large banks in the most extreme cases with minimal assistance from the Treasury. Accomplish that and let the owners and their employees hash out the division of the spoils.