Bankers have made some dramatic moves in recent years, but even the most cynical observers were stunned last week when David Bagley, HSBC Holdings Plc’s top compliance officer, resigned during a U.S. Senate hearing.

“As I have thought about the structural transformation of the bank’s compliance function,” he told the senators, “I recommended to the group that now is the appropriate time, for me and for the bank, for someone new to serve as the head of group compliance.”

Translation: I am taking responsibility for the complete failure of compliance on my watch.

The failure is indeed complete. Investigators working for Democratic Senator Carl Levin of Michigan have established a decade-long pattern of behavior in which HSBC, one of the world’s largest banks, provided money-laundering services to drug traffickers in Mexico and criminals around the world. The bank also broke U.S. laws restricting transactions with Iran.

These were not isolated occurrences. No doubt some bank employees had gone rogue, yet the problems went far beyond that, including willful blindness by senior executives. The point of compliance is to catch such behavior before it damages the brand and threatens to bring down the company.

Management Failure

The bank’s management failed in this regard, and the buck shouldn’t stop with Bagley. Chief Executive Officer Stuart Gulliver should take responsibility by stepping down. What’s more, his successor should break the bank into more manageable parts.

Something has gone very wrong on Gulliver’s watch. Why would any responsible board of directors trust him to clean up properly? Three arguments are being advanced for why he needn’t resign; none is convincing.

First, it is suggested that HSBC didn’t lose much from this scandal. The total fine is likely to amount to $1 billion (about 1/17th of last year’s profit). The bank’s shares fell only about 3 percent between when the news first broke and the July 17 hearing. Presumably, the market reaction was limited because the bank’s U.S. and Latin American businesses account for less than 15 percent of operating profit.

How much damage has really been done, and how far does this failure of compliance go? It is very hard to tell with a huge bank like HSBC, and it would be wise to presume the worst. I agree with Mike Mayo, a respected bank analyst at Credit Agricole Securities, who said recently that large banks are increasingly difficult to analyze, making it hard to know whether they are good or bad investments. At this point, HSBC is so out of control that breaking it up would be good for shareholders. Who wants to invest in a bank where management doesn’t know what is going on?

HSBC is also reported to be under investigation for fixing benchmark interest rates, including the London interbank offered rate, known as Libor, and its euro counterpart, Euribor. It is a prominent member of 10 Libor panels. With the full scope of the inquiries not yet known, might other legal disasters loom?

The second argument for keeping Gulliver is that he had nothing to do with the bank’s Mexican business. There was a time when CEOs took responsibility for major compliance failures. Last September, for example, Oswald Gruebel stepped down as CEO of Swiss bank UBS AG after unauthorized trading led to losses of $2.3 billion.

Part of the CEO’s job is to make sure the company follows the law. No one expects the top executive to be involved in every transaction or to personally review every trading position.

Highly Compensated

CEOs, however, are compensated highly because they are supposed to make sure the proper systems are in place to avoid illegal activity. (Gulliver’s 2011 compensation package, at 7.2 million pounds, or $11.3 million, touched off a political storm in the U.K. over financial executives’ pay.)

Third, some commentators point out that HSBC is a global bank not fully subject to U.S. or U.K. authorities. It has a balance sheet of about $2.5 trillion (depending on whether you follow U.S. or international accounting rules), or roughly the same size as the British economy. It boasts of having about 300,000 employees serving 100 million customers out of 7,200 offices in 85 countries and territories around the world.

As such, HSBC is too big to fail. Executives speak of the bank as being “backed by the balance sheet” of the U.K. and the willingness of British taxpayers to provide bailouts (or not ask too many questions when the political class arranges one). Any illegal behavior that reduces shareholder capital -- a big fine imposed by U.S. regulators, for example -- exposes the U.K. taxpayer to greater risk.

Big banks benefit from large, opaque and dangerous government subsidies. The subsidies are a form of crony capitalism that should be ended, exactly as Jon Huntsman, the former Republican presidential candidate, has suggested. These banks should be broken up and made small enough to fail.

If the megabank continues to exist and the subsidies stay in place, there is no market discipline that will constrain bad behavior. Regulators must, in this case, prevent management from behaving in a reckless manner.

The Bank of England and the U.K. Financial Services Authority would be foolish to ignore what has happened at HSBC. They should expect members of Parliament to take a keen interest, particularly given the Libor scandal at Barclays Plc.

An informed and focused public outcry can have a major effect. Through the activities of HSBC, the British taxpayer has been effectively enabling the dealings of Mexican drug cartels. How can this not be a political scandal of the first order?

Gulliver has given no indication that he intends to resign. Former Barclays CEO Bob Diamond was similarly defiant -- until he was gone. His resignation was entirely appropriate. Diamond presided over illegal behavior by Barclays’s staff. If he didn’t know what they were doing, that just speaks to his inability to be an effective CEO.

The U.K. taxpayer should demand the same outcome for Gulliver. And the HSBC board should hire a replacement who commits to creating value for shareholders by breaking up what has become a too-big-to-manage bank.

(Simon Johnson, a professor at the MIT Sloan School of Management as well as a senior fellow at the Peterson Institute for International Economics, is co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.” The opinions expressed are his own.)

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To contact the writer of this article: Simon Johnson at sjohnson@mit.edu

To contact the editor responsible for this article: Paula Dwyer at pdwyer11@bloomberg.net