Banks are lowering bonuses to defuse popular outrage, but by curtailing employee incentives, compensation experts say the banks and the U.S. government are failing to fix practices that led to the financial crisis.

Bonuses and lavish perks for bank staff attracted public fury as the two-year-old financial crisis triggered billions in writedowns and credit losses, and prompted the U.S. government to set aside $700 billion to bail out banks.

U.S. President Barack Obama said Wall Street pay practices rewarded excessive risk taking and the government took steps to restrict bonuses at banks that got the most bailout money.

But even banks that returned government funds, such as JPMorgan Chase & Co (JPM.N) and Morgan Stanley (MS.N), are trimming bonuses and offsetting these lower payouts by raising salaries. Corporate governance and pay experts worry that banks are not effectively motivating staff for the longer-term benefit of the companies and their shareholders.

The fear is, are we going to end up with a bunch of people that are overpaid and unmotivated? said Alan Johnson, a compensation consultant with Johnson Associates in New York.

There's little doubt that the old bonus system was broken. Despite a dismal 2008 on Wall Street, more than 4,700 bankers and traders got bonuses of $1 million or more, according to a survey from New York's attorney general last month.

A day after the survey's publication, the U.S. House of Representatives approved a bill that would prohibit incentive-based pay packages at large financial institutions if the packages are found to induce excessive risk-taking.

Lawmakers also have suggested capping pay, and the Obama administration has appointed a compensation czar.

These moves may address popular unrest over bankers' bonuses, but some corporate governance experts view them as steps in the wrong direction.

If the bonus system is constructed properly, having more compensation paid in a bonus is better, because you can really change behavior and channel the motivation, said Eleanor Bloxham, chief executive of corporate governance advisory firm The Value Alliance.

Bankers' and traders' bonuses should be linked more closely to the longer-term profits of their business rather than the risk they are taking, Bloxham said.

Many banks pay some compensation in restricted stock that vests over time. Credit Suisse Group (CSGN.VX), for example, has based a bonus plan on illiquid assets. But pay experts say banks could go further to link staff rewards to performance.

Instead, a trend is emerging for banks to raise salary levels to offset smaller bonuses. Citigroup (C.N), which received $45 billion in bailout money, has raised salaries for employees, according to sources.

JPMorgan last month unveiled plans to boost salaries of those earning a substantial part of their compensation in bonuses, according to a source. Morgan Stanley said in May it is more than doubling base salaries of senior officers to $800,000.

AVOIDING MELTDOWN

While salaries are rising at the expense of bonuses at some firms, banks likely will pay sizable one-off rewards this year. Johnson expects that bonuses will rise on average by about a third compared to 2008, though bonuses will vary widely between businesses, and they will be lower than payouts made in 2007, according to a report his company published last week.

Raising salaries is not automatically a disincentive to work hard. I think it's likely to have zero effect on how people perform in their jobs, said Robert Sedgwick, head of the executive compensation practice at law firm Morrison Cohen.

But from a corporate governance point of view, government interest in capping pay and banks' drive to raise salaries do little to address the link between bankers' and traders' appetite for risk and the potential for financial meltdown if they are rewarded only for annual performance.

While raising salaries may be an easier short-term solution, I don't think that really drives at what created these problems in the first place, Bloxham said. What's most important is to examine why the bonus structures didn't work and fix that.

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