Will the big banks ever clean up their act?

Federal Reserve Bank of New York President William Dudley delivered a stern warning to the largest banks in a speech earlier this week. Either clean up your illegal and unethical behavior through "cultural change" from within, he said, or be broken into smaller, more manageable pieces.

In his conclusion, the warning was direct and explicit:

"...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."

How can the needed change be accomplished? Dudley suggested several steps banks can take to bring about the needed corrections in behavior. After documenting the "ongoing occurrences of serious professional misbehavior, ethical lapses and compliance failures at financial institutions," he stressed that change must begin with the firms' leadership. The leaders must set the proper tone within the firms and set standards for proper behavior that are strictly enforced.

To facilitate this, the boards of directors must choose leaders with these capabilities and hold those leaders accountable if they fail to set the correct cultural standards. And when problems do occur, the banks must impose fines, penalties, dismissals and legal action.

Dudley also emphasized that "senior leaders of financial firms, and those who report to them, must also be proactive in reporting illegal or unethical activity" and that the proper financial incentives can induce senior leaders to act in this way.

If a substantial portion of managers' compensation at large financial firms is deferred for many years -- because it takes time to uncover and establish accountability for this type of behavior -- and if the deferred compensation is at risk if wrongdoing is detected, then managers will have a strong incentive to root out and stop behavior that might put these "too big to fail" firms at risk.

Will this work? Will large financial firms take the threat that they might be broken up seriously? Will they even bother to implement the many suggestions Dudley made?

Regulators have been reluctant to break up big banks in the past out of fear that it might undercut their ability to finance very large projects and hurt their competitiveness in international markets. And given that this behavior is so pervasive and has endured for so long, regulators haven't been as tough as they could be in stopping it.

Maybe this time is different. Maybe financial firms believe regulators are serious, and they will change the culture that has allowed these problems to exist. Perhaps the threat to break up the banks if they continue to prove they are "too big to manage" is real.

Let's hope so, because the financial instability that can occur when large banks behave unethically or when they fail to comply with existing regulations can be very costly for the nation's economy.