As the end of the year approaches, John Mack isn’t in a very enviable position. Mack, who won’t hand over to his successor until 2010, needs to find a way of keeping existing Morgan Stanley people happy, while paying up for the 400 traders he wants to hire.

According to the UBS banking analyst Glenn Schorr, who met with Morgan Stanley CFO Colm Kelleher in the past few weeks, Morgan Stanley is, ‘surprised at how hot the war for talent has become considering where the industry was just six months ago.’

Reading between the lines, Morgan Stanley is clearly having to pay more than it anticipated to attract traders, even though acknowledges they won’t contribute to the bottom line in the third quarter. It will also need to pay its M&A bankers well following their strong performance in a difficult market this year, and in anticipation of a bigger year for M&A in 2010.

Unfortunately, Morgan Stanley doesn’t look well placed to be generous. Its compensation ratio already stood at 71% in Q2, compared to an industry average in the region of 50%.

This could rise even higher, particularly if Morgan Stanley wants to maintain the pretence of keeping up with Goldman Sachs and prevent poaching by the likes of Barclays Capital. According to Citigroup analysts (who met David Viniar), Goldman Sachs is having a phenomenal year and it’s likely that the absolute size of its compensation payouts will “rise significantly.” Despite this, Goldman says its staff are being lured away by promises of higher pay elsewhere.

Evidently aware of this, Kelleher reportedly told Schorr that Morgan Stanley is prepared to whack up pay if necessary, “even if there may be some headline noise that comes along with a higher comp ratio.”

However, Schorr also said that, “Management does not expect to see a set compensation ratio put in place by the regulators as it could back them into a corner.”

Unfortunately for Schorr, therefore, last week’s G20 meeting in Pittsburgh, did make provision for caps on compensation ratios, but only at banks that are considered undercapitalized. With no definition of what undercapitalized is, Schorr will have to hope that Morgan Stanley’s 8.1% tier one capital ratio will be sufficient to allow it to pay the bulk of its revenues out in compensation. If not, it will find itself in a very tight corner indeed.