Federal Reserve has power to force breakup of banks

The Federal Reserve has plenty of power to follow through on regulatory threats made to top bank executives aimed at curbing misbehavior on Wall Street, even if it can't order firms to break up.

"The Fed has a powerful bully pulpit that should not be underestimated," Mike Mayo, an analyst at CLSA Ltd. in New York, said. "It has the authority to approve or disapprove the ability of banks to return capital to shareholders."

Mayo and Karen Shaw Petrou, managing partner of Washington- based research firm Financial Analytics Inc., said the Fed also has wide discretion for action under its authority to ensure "safety and soundness" in the financial system.

New York Fed President William C. Dudley and Fed governor Daniel Tarullo reproached top Wall Street bankers this week for failing to eradicate a culture that encourages misdeeds that has resulted in more than $100 billion in fines since 2008. Dudley warned that big banks would be "dramatically downsized and simplified" if bad behavior persisted, and he proposed changing the way executives are compensated to discourage excessive risk- taking.

Both officials referred to scandals, including cases of foreign-exchange and interest-rate rigging, that erupted since the financial crisis. The pair gave separate speeches at a closed-door workshop attended by senior bankers at the New York Fed on reforming Wall Street culture and behavior.

Morgan Stanley Chief Executive Officer James Gorman, Goldman Sachs Group Inc. Chief of Staff John F. W. Rogers and JPMorgan Chase & Co. Chief Operating Officer Matthew Zames were among those invited to attend.

Andrea Priest, a spokeswoman for the New York Fed, declined to comment.

Arbitary Standards

The Fed wouldn't be able to set arbitrary standards for when a bank, because of size or complexity, must be dismantled, according to Wayne Abernathy, executive vice president for financial institutions policy at the American Bankers Association in Washington. That doesn't mean the Fed can't get what it wants, he said.

"What they could do is make it so difficult for the bank they could force the bank to break up," he said. "Their supervisory authority is so broad and so imprecise, they can use it to make it tough for banks to do anything."

That might mean imposing tougher reporting, capital and liquidity requirements on a targeted bank or holding back approval for distributing dividends, completing a takeover or even opening a new branch.

"They could make life miserable," Abernathy said.

Warren Call

Senator Elizabeth Warren, a Democrat from Massachusetts, called on the Fed to use its authority to make the financial system safer.

"It's critical that our regulators not only identify ongoing problems, but also take strong action to reduce the risks posed by the country's biggest banks," Warren, a member of the Senate Banking Committee, said in an e-mail.

Petrou said the Fed might force big changes short of breaking up banks, such as demanding that some operations be fully separated from others, with distinct boards of directors.

"If they said, in a supervisory action, 'We want operational ring-fencing,' it can do that under very broad safety-and-soundness regulation," she said.

Petrou said it was significant that both Dudley and Tarullo singled out trading operations as posing risks to the culture of diversified companies.

Warning Signal

"That's a very important early-warning signal on the growing focus of Fed thinking," she said.

Dudley and Tarullo called for changes in the way banks compensate employees. Dudley recommended that firms defer more compensation and pay more of that in the company's own debt, as opposed to equity, to encourage better behavior.

Regulatory fines levied against banks that still ran afoul of the rules could be paid out of debt set aside for managers, thereby reducing their deferred compensation, he added.

While the ABA's Abernathy didn't dispute the Fed's interest in regulating compensation, he urged it not to apply blanket rules.

"In as much as you can point to a compensation practice that promotes unsafe behavior, certainly that's appropriate for regulators to get into that," he said. "But it might be best to do it through the supervisory process, because you can tailor it bank-by-bank."

The warnings came amid questions over the Fed's own credibility as a regulator. Earlier this month, Dudley defended the New York Fed against allegations it had been too deferential to the big banks it oversees.

London Whale

The Fed's Office of Inspector General said in a report released yesterday that the New York Fed had botched its oversight of the JPMorgan office that suffered $6.2 billion in trading losses attributed to the so-called London Whale.

Jeffery Harte, an analyst at New York-based Sandler O'Neill & Partners LP, agreed the Fed can force breakups. He doubted they will want to.

"I don't expect to see the big banks broken up," he said. "I don't think they really want to go down that path. The ability to do it is one thing, but I'm not really sure I see how that would make their lives any easier."