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Libor and banker pay: An unfortunate marriage

FORTUNE – The Libor manipulation debacle has resulted in something rare in the world of banking scandals. British police arrested three people Tuesday, including one former Citigroup trader, in a predawn raid in London.

As much as the arrests may serve as a deterrent for future manipulation, it doesn’t entirely remove the incentives to repeat such behavior. UK regulators last week recommended that even more banks get involved in the process of setting the London Interbank Offered Rates. And some academics and former bankers are recommending executive pay schemes that could encourage even more rate manipulation.

The Libor price-fixing scandal has engulfed over a dozen mega-banks, including Bank of America (BAC), Citigroup (C), and JP Morgan (JPM).  And the banks’ alleged tampering has hurt taxpayers by lowering interest earned on some savings and retirement assets and decimating billions in state and municipal investment revenues. (This has come as a double whammy for communities that were already suffering from lower taxpayer bases due to the financial meltdown.) The Libor mess has also ramped up government spending on investigations — now in both the U.S. and UK.

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Given the widespread impact of the Libor scandal and the fact that most banks aren’t denying the charges, it’s strange that academics and former bankers are continuing to advocate the use of bonds or interest rate swaps to compensate top banking execs.

Bond prices rise if interest rates fall. So if you pay a banker in bonds, you are handing him a very direct incentive to manipulate rates in order to boost the value of the bonds he received as pay.

While I thought the idea of paying bonuses with debt instruments was a poor one two-and-a-half years ago, I did not realize back then that the game of interest rate finagling was already well ensconced in the halls of banking.

In the spring of 2010, several months before I wrote against these misguided pay theories, economists Conan Snider and Thomas Youle had already published research that indicated banks had been playing with Libor levels. Even without a bonus scheme to enhance their motivations, bankers appeared to have enough incentive to fiddle with Libor, according to their analysis, which suggested that “banks have large portfolio exposures to the Libor and have recently profited from [its] rapid descent.”

But of course, banks weren’t the only ones to benefit from such manipulation. Top bank executives would have benefited as well through increased bonuses tied to any boost in earnings. Board compensation committees will find they paid their CEOs for results obtained through fraud in the case of banks involved in the Libor monkey business.

Given this, it is hard to fathom why anyone would advocate paying top execs at banks with debt. But bonds-as-bonuses is just one example of business leaders trying to come up with remedies for executive compensation without thinking through the consequences. And if the Libor example can’t put a bullet in bad compensation ideas, I’m not sure what can.

One regulatory hope, an FDIC idea proposed almost three years ago to charge higher FDIC premiums to banks with risky compensation schemes, is essentially on hold. “The FDIC, along with other financial regulators, is continuing to work on an incentive compensation rulemaking under section 956 of the Dodd-Frank Act before considering and evaluating other action,” an FDIC spokesperson said in an email.

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Board compensation committees shouldn’t determine executive pay based on any number — be it earnings or shoe size – without examining what those figures really say about performance. Nor should they stick their heads in the sand and pay executives with stocks, bonds or interest rate swaps without considering how this may affect executives’ motivations.

Compensation committees should also implement bonus deferral programs for those at the top, to ensure executives have rightfully earned their pay. If JP Morgan’s board were serious about pay for performance, they’d have instituted bonus deferrals instead of shelling out millions way too soon. We’ll know whether that board is serious if at year-end they not only claw back CEO Jamie Dimon’s bonus for the losses on the CIO trades, but also ding him for generating risky earnings and a staggering litigation backlog (including any Libor costs). But don’t hold your breath.

Paying bonuses for fraud and harm?  It’s hard to see how that comports with reasonable business judgment.

Eleanor Bloxham is CEO of The Value Alliance and Corporate Governance Alliance (, a board advisory firm.