One variation of this pay scheme is for hedge funds and private equity firms which get paid a percentage of the amount of money they manage combined with a share of the profits they generate -- typically above a certain minimum level.

So what's the problem with how Wall Street gets paid? Participants get rewarded for closing lots of big deals. As I posted previously, this incentive drives bankers to take on bigger, riskier deals without regard for whether the deal will later go bad. Often when they're taking on the deals during a period of credit expansion, credit losses are low. So there is no apparent reason not to keep ramping up the deals' size and frequency.

By the time things start to go bad, the bankers have spent their bonuses on art, houses in the Hamptons, etc. And even if their reputations are ruined as a result of the bad deals they originated, nobody demands that they pay back the money they made when the deals closed. And a new crop of bankers untouched by these bad deals comes along every spring when MBA schools loose their graduates on Wall Street.

Who ends up paying the price for these deals? Sometimes, Wall Street cleans up its own mess as -- JPMorgan Chase & Co. (NYSE: JPM) and Citadel Investment Group did with the collapse of $6 billion hedge fund, Amaranth Advisors, last year. So far, no problem.

But when government needs to step in because of Wall Street's mismanagement -- as it did with the 1980s bailout of the Savings & Loan (S&L) industry, then society pays the price. In the S&L case, Wall Street contributed to the problem. Specifically, Michael Milken of junk bond dealer, Drexel Burnham Lambert, contributed to the crisis by brokering deposits to S&Ls which Milken demanded they use to buy junk bonds. When the S&L's loans went bad, 932 S&Ls failed and the U.S. government covered the cost -- $150 billion.

Incidentally, this is not ancient history I am talking about. What's come to light this week with The Bear Stearns Co.'s (NYSE: BSC) hedge fund hits brings this issue home. The big unknown at this point is whether Wall Street will clean up the mess itself or whether society will pick up the tab.

MY PROPOSAL

In my view there are two possible solutions. The first is to require that the companies that invested in and facilitated the bad deals pay all the costs of cleaning them up. When these costs exceed the stated capital of these firms, society should take a lien on their future profits until those costs are paid back.

The second is to put a portion, say 50%, of market participants' pay in an escrow account. The contents of that account would be held back to cover the cost of potential deal blowups in the decade following their origination. The magnitude of these accounts would be set to fund future charge offs of bad loans or investments gone south. If no blowups occurred, market participants would get the money in the escrow account.

One way to soften the blow of such a plan would be to enable bankers to trade their escrow accounts with each other. Such a trading process would enable bankers to set a de facto set of odds for the likelihood and amount of bad deals each had originated. Bankers who took on less risk would get a higher value for their escrow account than those who were more prone to undertake risk.

BENEFITS

My proposal would help solve the problem of foisting the cost of bad deals on society. It would require banks to get both the benefits of their deal making while paying all the costs of bad deals. Moreover, because my proposal would require them to delay receipt of part of their bonuses, it would motivate them to consider more carefully the risks of their deals.

I think my proposal will free society from bearing the costs of bad deals. But I don't think bankers would like it much. However, if I was in Congress, I'd be willing to stop threatening to tax carried interest at ordinary income tax rates -- effectively raising the rate on which private equity and venture capital gains are taxed from 15% to 35% in exchange for adopting my proposal to change Wall Street pay.

How so? Because the principle behind taxing earnings as a capital gain is that the gain resulted from taking a risk. And if a banker put half of his or her compensation in an escrow account pending the success of the deal, there would be little doubt that the capital was at risk.

Peter Cohan is president of Peter S. Cohan & Associates, a management consulting and venture capital firm. He also teaches management at Babson College and edits The Cohan Letter. He has no financial interest in the securities mentioned in this post.