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The Treasury Department and the Federal Reserve Board are involving themselves in bankers' pay in ways that would have been unthinkable a year ago. Wall Street may not like it but has only itself to blame. The industry's psychotic insensitivity to popular opinion throughout the crisis continues to astonish. The authorities are in large part responding to the public's justified anger: Something had to be done, they will tell you, and they are right. But you still have to ask whether these interventions will do more than take the edge off citizens' anger. Will they really make the financial system any safer?

The economy is still on its knees, but banks' profits have recovered. This was as the government intended, a sign that efforts to stabilize the financial system are working. No sooner had banks and other financial firms started to revive than -- still on taxpayer support, still short of capital, and with unemployment in the wider economy still rising -- they announced enormous new bonus pools for their employees. Thanks to massive injections of public money, their crisis was over. As far as pay was concerned, it was back to business as usual. If Wall Street wanted to enrage the country and bring the ceiling down on its head, it couldn't have done more.

The Treasury's special master for bankers' pay, Kenneth Feinberg, has capped salaries and bonuses at the handful of firms receiving help under the Troubled Asset Relief Program. The net is now being cast much wider. Grumbling bankers emerged from meetings on the subject with Fed officials this week. The board told them that it is moving forward with a review of 28 large and systemically significant financial institutions, and that it would be looking hard at pay. It set a February 1 deadline for banks to submit plans for new pay structures and said that bonuses for 2009 should take this into account straightaway.

"Some of the bankers called [the meetings] a waste of time," reported The New York Times -- nothing but an exercise in public relations. Well, if the industry knew what was good for it, it might pay more attention to public relations. There is more to it than this, however. Fixing pay structures in the industry is no cure-all, but the Fed and Treasury are right to say that badly designed contracts have undermined financial safety. Wall Street should have fixed the problem already, but it has not.

Raghuram Rajan, an economist at the University of Chicago's business school and a former chief economist of the International Monetary Fund, was on to this nearly two years ago. "Bankers' pay is deeply flawed," he wrote in the Financial Times. "Banks have recently been acknowledging enormous losses, yet those losses are barely reflected in employee compensation." He explained that a financial manager can always generate higher returns if he is willing to take on greater risk. A sensible pay system would not reward that behavior, because it requires no special skill or insight. Pay systems should aim to reward those few managers who are able to increase returns at any given level of risk -- a rare skill.

The Fed and Treasury are right to say that badly designed contracts have undermined financial safety.

Rajan also explained how financial managers can create phony safe returns by taking on hidden risks. This is exactly what happened in the years before the crisis. Managers who invested in AAA-rated mortgage securities got higher returns than those who invested in ordinary AAA-rated corporate bonds. It turned out that the extra return was compensation for extra risk. "If all the manager had disclosed was the high rating of his investment portfolio," Rajan went on, "he would have looked like a genius, making money without additional risk, even more so if he multiplied his 'excess' return by leverage."

Pay systems should not reward these false returns -- returns that are simply a reward for exposing the firm to extra risk, rather than discovering genuine new value. Why have the managers of financial firms put pay systems in place that do reward them? Good question. To a large degree, the interests of shareholders and financial regulators overlap in all this. When banks and other financial institutions reward excessive risk-taking by their employees, they are jeopardizing shareholders' long-term returns as well as the soundness of the wider financial system. So these bad practices are, among other things, a failure of corporate governance: Managers are failing to discharge their duty to shareholders, and shareholders are letting them get away with it.

Wider demands for corporate-governance reform are therefore highly relevant to the discussion on financial regulation. Corporate-governance reformers seek greater power for shareholders in their oversight of managers. They call for greater transparency -- which is particularly lacking in finance -- and for measures to give shareholders more clout on pay. The stimulus bill required firms getting TARP help to give shareholders a vote on managers' pay. Efforts to bring in a wider "say on pay" law, giving shareholders of all public companies that right (as Britain did in 2002), are supported by the Obama administration but continue to meet resistance. No industry better illustrates the managerial capture of enterprises from their owners than finance.

At the same time, though, Rajan's example of the excess return on AAA-rated mortgage-backed securities underlines the difficulty in getting incentives right, even when you have identified the problem. After all, the securities were indeed AAA-rated. Supposedly independent ratings agencies had vouched for the assets' safety. That turned out to be a mistake. This error was then aggravated by regulators, who required less capital to be set aside against such high-rated securities than against ordinary loans on the banks' books. In other words, the regulators themselves were unknowingly pushing investors to take on more risk.

Only after the fact is it possible to say that one bet was safer than another. The Fed's new guidance on pay takes this into account. It calls for performance awards that "reflect the risks of employee activities, deferring payments of awards and adjusting actual payments to reflect risk outcomes, using longer periods for measuring the performance on which awards are based, and reducing the sensitivity of performance measures to short-term revenues or profits." Bonuses in recent years would have been smaller if these rules had been in place -- good news for taxpayers and shareholders, and for Wall Street's reputation. It is harder to say, however, whether fewer risks would have been taken and the crisis thus avoided.

The pay changes that the Fed proposes are worth making, but by themselves are insufficient.

Withholding bonuses until the verdict is in, or clawing them back in the event of losses, would discourage some kinds of deliberate risk-taking. According to The Sellout, a new book on the meltdown by Charles Gasparino, when one Citigroup trader was told of a setback to house prices, he remarked, "What's the worst that could happen? We make $200 million and then we get fired." With clawbacks, that trader would have had something to lose.

But remember that most traders believed that mortgage-backed securities were safe. That is partly because regulators said they were safe -- safer than ordinary loans. And the rating agencies were telling everybody that they were safe. They were all mistaken. Pay systems that discourage risk-taking can only do so much if people are assessing risk in all good faith and getting it wrong.

The pay changes that the Fed proposes are worth making, but by themselves are insufficient. Other regulatory reforms in the works would do more to promote safety -- and, indirectly, curb the excesses of Wall Street pay at the same time. Regulators are proposing to increase the capital that banks and other financial firms are required to set aside against the risk of loans or other assets going bad. They are also considering new rules on leverage (the amount of borrowing a firm can do as a multiple of its equity) and liquidity (the amount of easily salable assets it must hold). A financial institution with more capital, less leverage, and more liquidity would be a safer operation -- and a less profitable one.

In thinking about future financial regulation, that is the fundamental trade-off. Taxpayers have learned that Wall Street's profits, and the fabulous pay that went along with them, have come partly at their expense. In effect, the industry has enjoyed a disguised public subsidy, in the form of a promise to underwrite its losses when things go wrong. Heads we win, tails you -- the taxpayer -- lose. In demanding a safer financial industry, as we should, we will be withdrawing that subsidy and thus insisting on a somewhat smaller and less profitable industry as well.

This, in turn, will mean less-outlandish pay. Shareholders in banks and Wall Street firms have given their employees a very generous deal in recent years -- far better than they have had themselves -- handing over about half of their revenues in pay. If finance shrinks, pay in finance will shrink. Reviewing the wreckage of the past two years, both of those things look eminently desirable.