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Some key investment banks are yet to report their latest quarterly results, but it increasingly looks as if the bonus pot shared among staff of the world’s largest investment banks will be larger than ever, write Peter Thal Larsen and Chris Hughes in Tuesday’s FT.

Even though several bulge bracket banks suffered catastrophic losses on US subprime mortgage-linked investments, many parts of their business enjoyed a record year in 2007 - a fact that has produced some surprising results.

Morgan Stanley, for example, reported a huge Q4 loss and raised $5bn in new equity from a Chinese state investment fund, but paid out $16.6bn in compensation last year — an 18 per cent increase. This pushed the ratio of compensation to revenues — a closely watched measure of cost discipline — to 59 per cent for the year. Most investment banks aim for a ratio below 50 per cent.

Morgan Stanley is unlikely to be alone. Citigroup and Merrill Lynch, which are both due to report fourth-quarter results this week and have both been forced to seek fresh capital, face a similar dilemma, as does UBS, which is due to inform staff of bonuses later this month, note the authors.

The problem is not just about how to reward good performers in spite of scarce financial resources. Uncertainty over the economic outlook also makes it hard for banks to predict which business areas will be active this year, and therefore which staff they need to keep happy.

The challenge is reflected in the various ways banks have tackled the problem. At one end of the spectrum are those institutions — such as Goldman Sachs and Lehman Brothers — that have escaped large losses in the fixed-income business.

For them, the bonus round has been almost business as usual, with top performers well rewarded. Those identified as poor performers will have received little or no bonus — a bank’s way of suggesting they should start looking for another job if they do not want to be ignominiously presented with a bin bag and told to clear their desk.

Even so, the slowdown in corporate activity and the weakness in the bond markets has curtailed overall rewards even at the healthier institutions, notes the FT:

At Lehman, for example, individuals whose contribution was up 10 times would have seen their bonuses rise about seven times, according to a person familiar with its compensation policy this year.

Merrill’s compensation ratio — pay and benefits as a percentage of net revenues — is expected to rise to more than 70 per cent as it seeks to cushion key staff from feeling the pain of the bank’s losses. Some observers believe it could exceed 100 per cent if the bank reveals fresh losses on subprime securities.

UBS, meanwhile, has taken the controversial decision to cap cash bonuses and make up the difference with shares. Executives argue that the bank’s depressed share price makes this more attractive than in other years. Nevertheless, UBS’s rivals are expecting a rash of senior defections in the next few months.

Yet even if the investment banks are behaving rationally in attempting to hang on to staff, this year’s bonus round is bound to be controversial. The prospect of institutions whose behaviour helped create the current financial crisis continuing to lavishly reward staff is likely to add to pressure on banks fundamentally to rethink their compensation structures, note the authors.

The crisis has revived the debate about whether investment banking bonuses encourage excessive risk-taking.

Writing in the FT last week, Raghuram Rajan, professor of finance at the Graduate School of Business at the University of Chicago and former chief economist at the IMF, argued that banks should claw back payments to risk-takers who cream bonuses in good years but whose actions sow the seeds for large future losses.

It is an idea that appeals to investment bank managers and is being taken up by some institutions, says the FT.

For example, Credit Suisse each year holds back some of what it pays its proprietary traders, who take risks with the bank’s capital. If the traders do well again the following year, the retained bonus is released, plus an extra reward. But if their strategy blows up, they lose the retained part of the bonus.

This is all scant consolation to shareholders in investment banks, who are effectively subsidising the payout. Their only consolation is that if the broader business slows down this year, as expected, it will be some time before the bonuses reach such heights again.