Felix Salmon has written a post on Jeremy Stein’s proposal for reforming executive compensation in the major financial institutions. Basically, Stein seeks to factor in the risk that an MFI will receive extraordinary government support.

Managers who receive stock become more aligned with stockholders, but this does not align them with taxpayers. Managers and stockholders both capture the upside when things go well, and transfer at least some of the losses to taxpayers when things go badly. Stock options give managers even more incentive to take risk. Thus, compensation that is deferred to satisfy this regulatory obligation should be for a fixed monetary amount. For example, firms might be required to withhold 20% of the estimated dollar value of each executive’s annual compensation, including cash, stock, and option grants, for five years. At the end of this period, employees would receive the fixed dollar amount of their deferred compensation if the firm has not declared bankruptcy or received extraordinary government support.

The bailout has, rather depressingly, made this a very salient question: reluctant as we might be to regulate compensation schemes, the government has an obligation to protect the interests of taxpayers.