I am not habitually a defender of Congress. 

But despite the profound wrong-mindedness of the “TARP bonus bill” passed by the House, I can sympathize with the desire to give some expression to the public’s seething fury.  Something had to happen; outrage abhors a vacuum.

It is not too late, though, to find a more productive way, as the President might say, to “channel” our collective outrage.

First, let’s recap the single biggest problem with Thursday’s bill, which seeks to use the tax system to create, in practical terms, a pay cap for any large recipient of government capital.   No private company would find it palatable to abdicate its responsibility for compensation decisions.  For all their troubles, banks are no different.   This weekend, I can assure you, bank boards and management teams across the country were furiously trying to convince themselves that, on second thought, they don’t need or want TARP capital after all. 

But banks know that they can’t let their capital ratios fall precipitously.   Realistically, banks can’t raise the numerator in their capital ratios by raising new private capital (those markets will be shut as long as toxic assets remain).  So they will instead seek to reduce the denominator -- by shrinking their loan books further.  It’s one thing for banks to have driven their own equity valuations off a cliff.  But it’s quite another if Congress intentionally induces a collective bank management response -- to hunker down and pull back further on credit -- that drags the entire global economy off a cliff with them.  Simply put, Congress’s reaction has the real possibility of further forestalling what already was going to be an agonizingly slow recovery. 

So what is Congress to do?  After many hundreds of billions of taxpayer dollars have been thrown into what looks increasingly like a bottomless pit, simply doing nothing feels too much like acceding to banks’ implied threat:  “Give us our bonuses, or the economy gets it!”

Let me suggest an alternative approach, with three major features.

First:  Compensation reform should not just impact TARP-recipient firms, but all banks and quasi-banks.   TARP is merely the most visible taxpayer support of the banking system; the truth is that all banks rely on a very real economic subsidy, in the form of FDIC insurance, that absorbs the “tail risk” of losses, but gives private shareholders the benefit of gains.  That creates “moral hazard,” in which bank management teams have an incentive to swing for the fences, because the government pays the price if they strike out.

There are plenty of ways to mitigate this moral hazard, including prudent compensation structures -- like paying bonuses based on long-term performance, and appropriately risk-adjusting the profits that employees appear to generate.  And if compensation practices are meant to dampen the pernicious impact of this structural moral hazard, then those practices should apply to all banks, not just the big TARP recipients. 

An ancillary benefit of this approach, of course, is that it does not create a perverse incentive to refuse or repay cheap public capital, which everyone except bank boards seem to know that banks need. 

Second:  Reform should be forward-looking, and not retroactive.  For one thing, retroactive application feels vaguely like some old Fidel Castro newsreel footage.  And, more practically, no rational private investor is going to work with a government that, when it becomes upset, rewrites the rules of engagement after the fact.

Third:  As a people, we shouldn’t be forced to do bank boards’ jobs for them.  Congress should lay out the principles of compensation reform, and demand that banks (all banks) adopt new practices that, to the satisfaction of government regulators, meet those principles.  If those practices aren’t adopted by, say, year-end, then the House’s $250,000 pay cap, or some other Draconian measure, can become effective.  There is nothing particularly wrong with an in terrorem approach that forces bank boards to address this issue at long last.

Congress is right to be outraged.  But it can do better.

Raj Date is the Chairman and Executive Director of the Cambridge Winter Center for Financial Institutions Policy.  He is a former McKinsey & Company consultant, bank senior executive, and Wall Street managing director.