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The Fed is telling Wall Street banks to clean up their ethics or get broken up

Make 'em this small
Make 'em this small
Rob Kim/Getty

Speeches from Federal Reserve Bank presidents tend not to be very interesting, and indeed New York Fed President William Dudley's recent talk on "Enhancing Financial Stability by Improving Culture in the Financial Services Industry" seems to have been titled so as to maximize the number of people who ignore it. But he ended with a bombshell, telling CEOs that unless they clean up their acts, the Wall Street megabanks are going to get broken up.

Here's the crucial paragraph (emphasis added):

In conclusion, if those of you here today as stewards of these large financial institutions do not do your part in pushing forcefully for change across the industry, then bad behavior will undoubtedly persist. If that were to occur, the inevitable conclusion will be reached that your firms are too big and complex to manage effectively. In that case, financial stability concerns would dictate that your firms need to be dramatically downsized and simplified so they can be managed effectively. It is up to you to address this cultural and ethical challenge. The consequences of inaction seem obvious to me-they are both fully appropriate and unattractive-compared to the alternative of improving the culture at the large financial firms and the behavior that stems from it. So let's get on with it.

The point of the speech is that Dudley thinks that even if the senior managers at banks bear responsibility for the various fraud and market manipulation scandals that have left major institutions saddled with billions in fees recently — even if they aren't legally culpable. Corporate culture, he argues, is the root of the problem. Specifically, banks need to have corporate cultures where cheaters will be caught, exposed, and punished by their colleagues and "this only works well if they feel a shared responsibility to speak up, expect to be heard, and their efforts supported by senior management."

Dudley is not exactly a wild-eyed radical. He worked at Goldman Sachs before becoming a key lieutenant of Tim Geithner's at the New York Fed. And Dudley's not alone. Dan Tarullo, one of the most influential bank regulators on the Federal Reserve Board, also gave a speech that concluded on a similar note.

"If banks do not take more effective steps to control the behavior of those who work for them," Tarullo said, "there will be both increased pressure and propensity on the part of regulators and law enforcers to impose more requirements, constraints, and punishments."

The Fed could make this happen

The idea of forcing the largest banks to break up was widely discussed during the TARP debate of 2008, and again during the Dodd-Frank debate in 2010. But it never had anything approaching the necessary level of congressional or White House support to be close to reality. With Republicans having gained many seats since then (and set to gain more in November) it may seem inconceivable that any tough new regulations would be enacted. But as Christopher Condon and Matthew Boesler point out, the Federal Reserve could actually make this happen if they wanted to. The Fed probably couldn't specifically cap bank size, but as Tarullo said it could "impose more requirements, constraints, and punishments" and tie those constraints to bank size.

One of the most potent levers would be the Fed's authority to block banks from paying dividends or engaging in stock buybacks.

Dividends and buybacks are how bank shareholders get paid, so senior managers whose compensation is tied to stock performance are very eager to see them happen. And yet the Fed has fairly broad discretion over whether to approve or block bank dividend plans. A Fed that was determined to see banks shrink could simply stop approving dividends for excessively large or excessively complicated financial institutions. This would not, legally speaking, force banks to break up, but in practice CEOs would have no choice but to start drawing up plans to get smaller.

Political support still needed

Just saying... (Edward Kimmel)

One should not exaggerate the Fed's autonomy in this regard. The central bank operates independently of Congress, but does so because of authority given to it by an act of Congress. If the Fed started taking steps that were met with massive opposition from elected officials, it could be made to back down. Realistically, Fed officials wouldn't want to even come close to risking their precious autonomy through a bitter fight on Capitol Hill.

So don't expect to see the banks broken up just yet. But all the same, Wall Street can't count on congressional gridlock to save them. A Federal Reserve that wanted to act would need a critical mass of support on the Hill and in the White House, but it wouldn't need a filibuster-proof majority or necessarily any kind of majority at all, just enough of a backstop to prevent new amendments to the Federal Reserve Act from passing. None of that makes a bank breakup initiative likely, exactly, but it does mean that it looks a lot more likely this week than it did last week.