Does the credit crunch portend the end of lavish executive pay in the financial industry? Probably not, but it should surely lead to these schemes being reformed.

For years, bank executives justified their handsome compensation by pointing to two factors: their amazing ability to create shareholder value and the competitive market for so-called “executive talent” that demanded eight-figure pay packages in order to attract and retain top quality staff.

In the current environment, both rationales look painfully weak. It turns out that, at many firms, earnings performance was unsustainable. Past years’ profits are being given back in the form of huge writedowns, and the concurrent gutting of banks’ capital positions has left them unable to grow their core businesses for the foreseeable future. Not only have many executives’ performances been exposed as much weaker than advertised, but the profit-making prospects of the industry overall look weaker, at least in the short term, as firms reduce their leverage and likely face lower profit margins in the years ahead.

More gallingly, taxpayers around the world have been called on to backstop these crumbling institutions for fear that the folly of their executives is likely to cripple economic growth.

As a result, the industry’s former high flyers are facing government pressure to constrain their compensation.

The U.S. Treasury is imposing a handful of conditions on the pay of the top five executives at firms that take up its offer to help rebuild bank capital. It calls for firms to stop rewarding excessive risk taking, imposes clawbacks on pay for profits that are later found to be fundamentally flawed, and reigns in the provision of golden parachutes.

Similarly, the U.K.’s Financial Services Authority is calling on financial firms to craft more sustainable pay practices, not just for their five most-senior executives, but for the trading and investment banking businesses that took excessive risks, creating massive private rewards and now-socialized losses.

Over the past couple of years, shareholder activists have been stepping up their objections to runaway executive pay, and regulators were demanding more transparency. Now, if the current market turmoil isn’t enough to convince boards and ordinary shareholders that more credible pay practices must be developed in the financial industry, probably nothing will. IE