Public outcry over bonuses for bankers is predictable and right. The global recession came out of a crisis in the banking system. Reckless lending has created a contagion of bad debts. The banking system is being sustained by massive support from the taxpayer. Yet some of the worst-performing banks - notably the Royal Bank of Scotland, which last year delivered the biggest loss in British corporate history - are set to pay out close to £1 billion in bonuses. The controversy has been amplified by the news that the bankers recruited by the Government into UK Financial Investments Ltd to manage the state's £37 billion stake in the retail banks will themselves be eligible for bonus payments.

The Treasury has sought to defuse the controversy by ordering an inquiry into bank management. This is a welcome move, but it is important to distinguish genuine concerns about the health of the banking system from populist suspicions of high rewards. Not all criticisms of the banks are of equal merit. For example, the demand by Nick Clegg, the Liberal Democrat leader, that no bank executive ever receive a cash bonus has no merit, being in effect a demand that only low-achievers consider senior posts in banking. The same argument also applies to regulators.

Bonus payments are a standard part of senior bankers' remuneration. They also extend to quite junior employees. Bankers are typically paid a basic salary and an annual bonus that is intended to reflect firm-wide profitability and individual contribution. With more junior staff, the aim is to reward effort, progress and potential. In normal times, banking is a competitive business with high staff turnover. This increases pressure on banks to pay substantial bonuses to star traders and other direct revenue-generators.

There is nothing inherently wrong with that system, or with the notion of high rewards for generating profits. The Government is right to seek to limit the cost to the taxpayer of rescuing the banking system, but imposing a ceiling on bankers' pay would be the wrong approach. Governments have no legitimate interest in setting the rent of ability in the marketplace, even supposing they knew how to do so.

But there is still a problem. Even though bankers' bonuses will be substantially lower than in previous years - and will probably remain so for a long time - they will not adequately reflect the imprudent risks that the banks took on in the boom years. Bankers are paid for generating returns higher than those of the overall market. To generate consistent above-market returns depends on taking above-market risks. The banks have taken on huge risks that they did not adequately understand. A proper accounting for those risks would require bonuses that were paid in earlier years now to be clawed back. Those bonuses reflected notional trading profits made in the banks' treasury operations, proprietary trading desks and elsewhere. Yet the assets on which the profits were booked have been revealed as, in many cases, valueless.

The justification for a Treasury inquiry is not that enterprise should be penalised but that banks must be required to manage their risks better. Under new arrangements, bonus payments might take the form of deferred compensation schemes, whereby only part of a bonus would be paid upfront. The rest would depend on confirmation in future years that the profits are genuine.

Rewarding banks that reform their remuneration policies and penalising those that do not - possibly by mandating higher capital requirements - are a legitimate concern of government and regulators. Unless such reforms are made, banking will continue to be a mistrusted profession, whose benefits are enjoyed privately while its mistakes are paid for publicly.