Banks must change the way employees are compensated and take other steps to fix a corporate culture that encourages misdeeds or face being broken up, said William C. Dudley, president of the Federal Reserve Bank of New York.

If bad behavior persists, “the inevitable conclusion will be reached that your firms are too big and complex to manage effectively,” Dudley told industry leaders in a speech Monday at the New York Fed. “In that case, financial stability concerns would dictate that your firms need to be dramatically downsized and simplified so they can be managed effectively.”

Dudley’s comments, which follow bank scandals involving Libor and foreign exchange trading, were made at a closed-doors workshop attended by senior bankers at the New York Fed on reforming Wall Street culture and behavior.

Large U.S. banks were widely blamed for taking too much risk leading up to the 2008 financial crisis, which triggered the worst economic downturn since the Great Depression.

Lawmakers have since enacted a major overhaul of the rules designed to prevent banks becoming “too big to fail.” Dudley said it was fair to question if the “sheer size, complexity and global scope of large financial firms Monday have left them ‘too big to manage.’”

Barclays Plc Chairman David Walker, who also addressed the gathering, separately said banks should be allowed to overhaul their own culture, rather than have regulators do it for them.

Dudley, who has had to defend the New York Fed recently against allegations it was too soft on big Wall Street firms, suggested a number of ways to better align bank employee incentives with the interests of the general public.

These include deferred compensation plans that switch emphasis to debt, rather than equity, and a centralized, industry-wide registry for tracking individual offenses.

Fines levied against banks could be paid out of deferred debt compensation of senior managers, which would play the role of a performance bond, Dudley said.

“This would increase the financial incentive of those individuals who are best placed to identify bad activities at an early stage, or prevent them from occurring in the first place,” he said. (Bloomberg)