Does Goldman case help Chris Dodd?

(Fortune) -- Could the civil fraud case against Goldman Sachs be the break regulatory reformers have been looking for?

At first blush, the idea seems far-fetched. Republicans in the Senate have steadfastly opposed Democratic plans to rein in the big banks. Bankers' deep pocketbooks give them enormous pull in Washington, and public outrage over financial industry wrongdoing has been blunted by the hair-pulling detail of reform proposals.

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The Goldman case could help pass Sen. Chris Dodd's financial reform plan.

Yet some observers say the Goldman (GS, Fortune 500) case could swing the balance against the too-big-to-fail banks. It exposes the games Wall Street was playing while the housing boom inflated and then collapsed -- with devastating consequences on jobs, incomes and communities.

"This will strengthen the hand of the Democrats in pushing reform," said Douglas Elliott, an economic studies fellow at the Brookings Institute in Washington.

The shift could pave the way for the enactment of reform legislation sponsored by Sen. Chris Dodd, D-Conn., who chairs the Senate Finance Committee. The latest version of the Dodd bill, introduced last month, hasn't found a single Republican supporter.

Dodd and other Democrats wasted no time making the case for reining in the big banks on Friday.

"We must pass Wall Street reform to bring practices like these into the light of day and protect our economy from another devastating blow," Dodd said in a statement.

Sen. Mitch McConnell, R-Ky., has been saying Republican senators will stick together and defeat the Dodd bill. But the alleged misdeeds of Goldman, which has become the face of overpaid Wall Street slicksters, could make it painful for moderate Republicans to stand with the banks. Many face building anti-incumbent sentiment in November's congressional elections.

"This is going to have a major impact on the Dodd bill," said Simon Johnson, a finance professor at the Massachusetts Institute of Technology and co-author of 13 Bankers, a book calling for the biggest banks to be broken up.

The case against Goldman shows that the firm was attempting to "deliberately mislead" its clients, Johnson said. Even if Goldman contends that the executive named in the SEC suit, vice president Fabrice Tourre, acted on his own, it adds fuel to the case that the big banks are too big and too complex to manage.

"This goes to the heart of the banks' abusive relationships with their clients and their failure to control their people," said Johnson. "This shows what complexity has done in these giant institutions. It's a complete validation of what we've been saying."

The Dodd bill wouldn't break up the biggest banks. But a measure offered Friday by Sen. Blanche Lincoln, D-Ark., would force them to spin off the businesses at the heart of the financial crisis and in this case -- their highly profitable derivatives operations.

"This is another example of how risky Wall Street behavior puts our nation's financial system in peril and further illustrates the need for the strong reform that my legislation provides," she said.

A separation of trading and banking would hurt the big banks at a time when trading is practically the only game in town. Both JPMorgan Chase (JPM, Fortune 500) and Bank of America (BAC, Fortune 500) said this week that trading activity accounted for a large share of their profits in the latest quarter. Goldman stock tumbled 13% Friday, with the other major banks down 5% or more.

But the case for breaking up the biggest banks has been getting more official notice on both sides of the Atlantic. Andrew Haldane, the executive director for financial stability at the Bank of England, likened the banks to "polluters" in a speech last month.

He called for regulators to reach beyond typical regulatory levers such as setting capital levels and to consider more aggressive tactics, such as breaking up giant firms.

Richard Fisher, the president of the Federal Reserve Bank of Dallas, this week became the first Fed official to cite Haldane's view in a speech of his own.

Fisher said his experience at the Fed suggests that "the marginal costs of TBTF financial institutions easily dwarf their purported social and macroeconomic benefits. The risk posed by coddling TBTF banks is simply too great."

Fisher's opposition to the too-big-to-fail doctrine isn't new, but Johnson said he believes the comments by Fed and Bank of England officials show that policymakers "understand the magnitude of this issue."

To be sure, not everyone is buying the link between the Goldman case and regulatory reform. Joseph Mason, a finance professor at Louisiana State, dismisses the case as "a narrow enforcement action."

But others say the Goldman case means reform will soon lurch forward -- as long as the Democrats don't overreach.

"I already thought the chances of passage were high," said Elliott of Brookings. "This makes it even higher, unless the Democrats overplay their hand and unite the Republicans."