This is the first part of a two part special series on the banking industry. This series examines the banking industry and the deregulation that led to the current economic crisis, and what steps need to be taken to rebuild the financial industry. This first part examines the excess and hubris of the financial industry, and the need to link pay to performance, and the second part will examine the nature of the banking industry, the "crisis of confidence" and how America can get our financial industry back on track.

From our country's birth through the 1930's there were boom and bust cycles occurring approximately every fifteen years. With the Great Depression, an especially hard bust cycle, economists, politicians, and the general population realized that something must be done. Three major pieces of legislation was created to break the cycle: the formation of the Security Exchange Commission (SEC), Glass-Stiegel (of which Section 20 separated commercial banking and investment banking), and the creation of the Federal Deposit Insurance Corporation (also part of Glass-Stiegel). For almost fifty years this legislation kept the financial industry in check and evened out the boom-bust cycle. Starting in the 1990's, the Reagan Revolution brought with it a blind faith in free markets. The theory dictated that capital would flow to those industries and companies where it can be put to the best use, and flow out of companies where managers were overpaid, poorly run or committed abuses. The idea that survival of the fittest was a more effective means of regulation that any law and oversight bodies. Deregulation became the watchword of the day and over the next twenty years, across multiple administrations of both parties, these pillars were weakened and undermined, which ultimately led to failures at the SEC, FDIC, the repeal of Glass-Stiegel, and unregulated derivatives - culminating in the current crisis. This was egged on by the financial industry itself, which saw itself grow its portion of corporate profits, proof, it claimed, of the success of deregulation. PBS Frontline reported that over 20 years $300 million was spent by large banks to erode, and ultimately repeal Glass-Stiegel.

A constant stream of public industry leaders migrated from the financial sector to key positions in the public sector and back again, providing a platform to express the financial industry's views - leading to financial advisors and regulators that acted more as cheerleaders rather than executing effective policy and oversight. The SEC's failure to monitor the industry lead to the junk bond crisis, Enron, and Bernie Madoff among other activities. The FDIC failure to monitor banking risk leading to the Savings and Loan crisis and the current bank meltdown. The repeal of Glass-Stiegel broke down the wall between investment banks and commercial banking activity - creating public companies that took on unlimited risk. Every day was a day to swing for the fences, to hit a homerun, without regard to risk associated with it. After all, one can see with the growth of financial services' profits as a the percentage of GDP, these were the "Masters of the Universe". However, little oversight and deregulation brought some of the worse too. Movies such as "Wall Street" and books such as "Liar's Poker" were suppose to be cautionary tales on the excesses of Wall Street - but quickly turned to cult favorites, essentially how to get rich on Wall Street guides. This culture of excess can best be seen in the audacity of Wall Street's $18 billions of bonuses in 2008, more than $110,000 per employee, the fifth highest bonus ever, while overseeing one of the worse years in Wall Street since the Great Depression.

Wall Street is all about managing risk. Investing at its root is relatively straight forward. There are three variables that interplay: risk, reward, and liquidity. Take a bank Certificate of Deposit (CD). Walk into a bank and you'll see one rate (lower) for a 3-month CD, and another rate (higher) for a 1-year CD. Both have equivalent risk, since they are both FDIC insured, but since you lose liquidity by locking up your money for an entire year, the bank pays you a higher rate of return. Likewise, if you invest in 90-day commercial paper from a top triple-AAA rated company you'll get a lower rate than from 90-day commercial paper that has junk bond status because the risk of default is so much higher. The professionals on Wall Street spend most of their time measuring and pricing financial instruments based on these variables. Of course, the rating agencies such as Fitch's, Standard and Poor's and Moody's, who in current financial meltdown played the role that was played in 2000 dot-com financial meltdown by the "independent research analysts" who turned cheerleaders. After all, these agencies are paid by Wall Street to rate the investments - the higher the rating, the lower the interest rate that has to be paid, and the more of deal the investment houses can pocket. (There is an eerie similarity between the rating agencies that lost their primary mission and the analysts in 2000 that would pump up stocks in a pay-to-play scheme so their investment banking divisions could rake in lucrative fees). Under pressure from the large investment banking houses these agencies often gave top AAA ratings to the toxic derivatives that are now virtually worthless and clogging the arteries of our financial system. But besides some of this outright corruption, measuring risk has always been a challenge and can be very wrong. There are just a lot of variables and a lot of uncertainty.

For professionals, whose job is to measure risk - and one who often got it wrong, managed to get it quite right when it came to their own pay. They maximized the return and minimized risk - uncoupling pay from performance. To some degree this is a historical accident, quickly manipulated by greedy bankers. Initially investment banking houses such as Bear-Sterns, Lehman Brothers, Goldman Sachs and Morgan Stanley were partnerships. At the end of the year, the profits of the firm would be split among the partners. In theory, if the firms lost money, there could be a "capital call", where the partners would each be responsible to cover a portion of those losses. This created a natural breaking mechanism, preventing firms from taking on too much risk. With the repeal of Glass-Stiegel, commercial banks - usually publically traded entities - got into investment banking, and one by one these partnerships either were bought or went public. This meant that risk for losses were shifted from the partners and onto share holders. Reluctant to give up their multi-million dollar pay days, managers of these new financial entities continued the practice of paying huge salaries. No longer constrained, employees argued that rather that their payouts should no longer be tied to the overall success of the firm, rather on their own contribution. This quickly led to a slippery slope, where employees negotiated their own goals - often creating guaranteed bonuses and bonuses with criteria so low that a brain dead monkey could achieve them. Hence, the bonuses we saw in 2008 were largely negotiated based on performance in 2007, and was largely divorced from real performance goals. In addition to this decoupling of pay and performance, with little incentive to manage risk, the financial companies went all out - assuming unlimited risk, hoping for a homerun.

If risk is to be properly managed, there must be rewards and penalties tied to the risk. As a small business owner, if I wanted a line of credit to expand my business - I had to personally co-sign the loan, becoming jointly and severably liable for repayment. That means the bank could take my assets, my house, my children's college fund - anything and everything to get repaid. Since there was real and immediate downside to my actions, you can bet that I was careful with my investment. I would reap the rewards if my firm did well, and would suffer the consequences if my firm did poorly. It's high time that we reinstate the risk/reward within not only the financial industry but all publically held companies.

Do not mistake this for a call to limit executive pay - just link reward and risk, pay and performance. Across America we have always appreciated reward. No one begrudges someone for doing well. It isn't frowned upon if our baseball heroes make nine-digit salaries, or someone wins the lottery, or makes a fortune as a CEO or business founder. We all look upon that hope that we'll be in their shoes one day. To take an example of how this risk-reward is so engrained into society, look at tipping of waiters and waitresses. In certain places in Europe the tip is included as a "service charge" regardless of the quality of service - often 10%, and if exceptional service is provide the diner might leave a few extra coins. In America, except for large parties, service charges are never included and it's up to the diner to decide the tip provided - often 15% or higher. So in America we take larger risk and get greater reward - we've linked pay to performance.

Risk and reward should be connected, but until we (as a nation) force bankers to re-link their pay to their performance, we are going to continue to see risky behavior on Wall Street. Politicians need to stand-up to Wall Street, put in place legislation that provides the real owners of these companies real say in how companies are run and in executive pay. We would suggest that for publically held companies, all pay packages for top executives must be approved by shareholders. If voted down three times, the management team should be fired.

Take, for example, Home Depot's Chief Executive Officer Robert Nardelli who lost market share to Lowe's Cos. In the six years he ran the company, and the shares declined 7.9 percent vs Lowes' which rose 188%. In spite of this poor performance, during his tenure at Home Depot, Nardelli was compensated about $240 million, including stock options. Just before his departure, the “You can do it, we can help” board awarded Nardelli with a $7 million bonus and $14.7 million in stock - when his contract didn't require it.

Home Depot is an easy target, but not the only one. At Pfizer, Henry A. McKinnell left with an exit package worth $213 million, including an $82 million pension, after the pharmaceutical giant he ran for six years lost over $137 billion in market value on his watch. Jay Sidhu, the former chairman and chief executive of Sovereign Bank, received $44 million last fall when he was removed after a bitter proxy fight. Morgan Stanley's board awarded Philip J. Purcell an exit package worth more than $95 million when he was forced out in July 2005. Tom Freston, who was ousted at Viacom in September 2005, and Carleton S. Fiorina, who was forced out by Hewlett Packard in February 2005, were handed tens of millions of dollars when they abruptly stepped down. And these are just examples of CEOs who were paid obscene amounts of money to fail. It's across board - whether a CEO fails or succeeds they are receiving ever increase amounts of pay. According to the 2008 survey by the non-profit group United for a Fair Economy, the average pay is more than 344 times an average worker in 2007, compared with 42 times in 1980. These are but a few examples of run-away pay and a decoupling of pay and performance.

How did we get here? Mainly because the bosses set each other's pay. By serving on each other's boards, especially compensation committees, each vote they have jointly driven up each other's pay. Shareholder resolutions rarely pass, and when they do they are non-binding and often ignored by the board of directors. Hedge funds and mutual funds are largely responsible. With a few notable exceptions such as CALPERs, the California Retirement Fund, most companies that run these stock funds also have other business before the company - investment banking, commercial banking arrangements, and the like - so they tend to vote with the board.

Congress needs to let the real owners of companies, not just financial companies, but all companies start to have real say in how a company is run. It should be run for the benefit of the shareholders, not the bosses. By linking pay and performance, we'll see better run companies. Likewise, if pay and performance were truly linked on Wall Street there would have been no way that $18 billion in bonuses could ever have been paid out in 2008.

In the next installment, we will examine what it will take to restore confidence and fix the financial industry.