So far, I count four Federal Reserve Bank presidents out front in their calls to break up big banks.  To be sure, one of them sides with the Board’s approach, which plans to do this only through walloping capital charges instead of mandatory divestiture.  Cold comfort — this unprecedented campaign within the Federal Reserve System to bust up big banks poses a formidable set of strategic challenges to behemoth banks.  But, it’s actually just the front-runner to an even more profound challenge to banks big and small:  a redefined bank business model required not to promote profit, but rather to enhance social utility.

First, some details about dissent within the FRB.  In the last week or so, we’ve been deluged by frontal, forthright and high-profile TBTF attacks from the heads of the Dallas, Richmond and Kansas City Feds.  The head of the San Francisco Bank said he disagrees with his peers not on the goal of taking out TBTF, but rather on how to do it.  The other Reserve Bank heads favor a set of express sanctions.  This approach is one to which supervisors and lawyers naturally turn, but economists like the San Francisco president, John Williams, are more comfortable with using the power of the purse.  Thus, joining all the economists at the Board of Governors, this approach is to “tax” big banks through onerous capital charges to give them an incentive to break themselves up, rather than to issue a set of express size or activity limits.

From a big-bank perspective, this is a choice between the lesser of two evils:  dismemberment by immediate blunt force or long-term torture.  But, this isn’t all the body sculpting big banks may confront.  And, it isn’t just the very biggest banks who might face the next knife.

As noted, demands are growing not just that big banks be cut down, but also that all banks do only what benefits society as a whole.  Importantly, these calls come not just from expected quarters – the social liberals who once spawned the Community Reinvestment Act – but now also from unexpected and sometimes quite conservative voices. For example, free-market folk have rallied around a recent University of Chicago proposal to subject financial products to something like the Federal Drug Administration (FDA).  The financial FDA would scrutinize products not for the prudential considerations affecting offering institutions to which bank regulators turn, but instead to determinations of whether products and services are good for those who might make use of them. Often cited by fans of this approach is the need to subject OTC derivatives to “good-for-them” scrutiny to be sure that simple, low-cost derivatives really transfer risk that really needs to be transferred.

We will shortly turn to an in-depth assessment of the impact the social-utility theory of banking will have, as it’s a fascinating topic from both an intellectual and strategic-planning point of view.  At the heart of this question is whether banking products – wholesale and retail – should be regulated like lipstick, cigarettes or crack cocaine.

Historically, banks and their regulators have viewed bank advisory, asset and liability products like any other market offering – the customer might not need it, but if persuaded to want it, then there’s money to be made as long as the product isn’t actually poisonous.  These products are thus arrayed on tempting shelves with clever names and it’s up to the buyer to decide if the offering is becoming and the price is right.  Of course, cigarettes are the other class of consumer products or, to go one farther, there’s crack cocaine.  These are offerings society thinks need either stringent regulation to ensure sale only to suitable buyers or, if too risky, a total prohibition based not on harm to the offerer (pusher?), but to the user and or even society as a whole.

As is patently obvious, lipstick, cigarettes and crack cocaine have different business models.  If social-utility demands increase, then bank products would be divided by regulators into one of these three categories.  Woe betide the bank that proffers what comes to be prohibited, but even banks allowed to sell “lipstick” banking would learn that the Durbin Amendment is only a foretaste of rules to come.