The financial industry may face an even more extreme makeover than it's already had.

The intervention of the U.S. government and its counterparts around the globe to shore up the international financial system has ignited a furious debate over how to prevent banking and insurance conglomerates from ever again dragging the world's economy over a cliff. The financial world will be remade, both by market forces and by regulatory overhaul, in the wake of the leverage and risk binge that brought on the economic crisis.

Government officials and economists are already reflecting on -- and arguing about -- where to take the industry.

There's little agreement now about where the sector will end up. The harshest critics insist the industry must get smaller, both by size of the biggest banks and investment firms, and as a component of the overall economy. Others counter that giant financial conglomerates are inevitable byproducts of a global economy.

The most sensible reaction to the industry's recklessness, they say, is better regulation and closer scrutiny of the risks built into the system.

A downsizing of the financial industry is inevitable, insists University of Texas economist James Galbraith. The only question is whether governments will permit global conglomerates -- many propped up with public support -- to use the taxpayer capital they have received to gobble up smaller rivals or whether the officials will force these too-big-to-fail institutions to break apart.

Galbraith, a vocal critic of efforts to shore up the likes of Citigroup Inc., Bank of America Corp. and Wells Fargo & Co., is adamant that the giant institutions be diced into smaller, less complex firms. No firm, he says, should be so large that it becomes enmeshed in a tangle of financial relations so intertwined that it causes a cascade of failures and a global panic if it goes out of business.

"It's common sense," Galbraith says. "Some institutions got so big, AIG for instance, that they cannot be managed or regulated."

He adds that at its "bloated peak" in early 2007, the financial industry accounted for 10% of all wages and 30% of all profits in the U.S. Given that those numbers supported an industry hell-bent on leveraging profits from borrowed money, it's clear a more prudent industry cannot support that kind of footprint. "Banks are going to be more cautious," he says. "The kinds of models they were engaging in were not viable and should never have been permitted in the first place."

How will the industry reduction occur? Leaving it to evolve on its own will more than likely lead to the further erosion of local community and regional banks, which lack the muscle to fight off the money center banks, Galbraith warns. The largest U.S. banks have a big advantage in the coming shakeout because they have received hundreds of billions in capital and guarantees from the federal government.

Galbraith says unless government officials step in to break up the biggest firms or take over the ones in the worst financial shape, the industry's reduction will come at the expense of small and regional institutions. Preserving conglomerates that have proven too unwieldy to manage "doesn't make sense," he says. "Giving people a license to run their institutions into the ground is no way to regulate an industry."

Galbraith says government can better direct the industry to remake itself by seizing insolvent institutions, including the weakest money center institutions, and selling them to new owners. The most complex institutions can be sold off in pieces, he says.

The economist favors fostering a mixture of community and regional banks and perhaps a few money center banks with a simpler structure. "Manageable institutions that can be regulated strike me as the right way to go."

Martin Baily, senior fellow at Brookings Institution, counters that a government campaign to break up six of the largest financial institutions would be disruptive and would hurt the U.S. financial sector's long-term competitiveness in international markets.

"We need very large financial institutions, given the scale of the global capital markets," he says. As a consequence, some of these large firms would continue to be viewed as too big to fail. "For U.S. institutions to operate in global capital markets, they will need to be large. Congress should not punish or prevent organic growth that may result in an institution having too-big-to-fail status," he told the Senate Banking Committee on May 7.

Baily, on the other hand, does favor breaking up conglomerates if federal regulators have to take them over. After seizing an insolvent institution, the government should operate it under a presumption that it will be broken into pieces that do not pose a systemic risk. Regulators also should avoid selling any of the pieces to an acquirer that itself would become a systemic threat because of the sale.

Baily says capital standards for large banks should be raised progressively as they increase in size and according to other risks they pose. Regulators also should be able to prevent financial mergers that would "unduly" increase systemic risk.

Big banks in the past have brayed that their competitiveness will be diminished if they are called on to post greater capital. But Baily says the implied government backing afforded to too-big-to-fail institutions allows them to borrow funds at 50 basis points lower than their smaller rivals. "This means that some degree of additional regulatory costs can be imposed on large financial institutions without rendering them uncompetitive," he says.

In her testimony to the Senate Banking Committee on May 6, Federal Deposit Insurance Corp. Chairwoman Sheila Bair acknowledged that the federal government's interventions over the past year and a half have reinforced the perception that the largest institutions won't be allowed to fail. She has been making a full-court press for creation of resolution powers that would allow financial regulators to seize a nonbank financial institution and turn it over to the FDIC to be sold to new investors or liquidated, just as her agency already does for the narrower sector of federally insured banks and thrifts. Once the government's powers are spelled out, creditors of financial conglomerates will know their investments can be lost. As a result, they will no longer tolerate the kinds of risks that dragged the industry into today's mess, she said.

Bair also supports stricter capital standards for institutions that issue credit default swaps and other complex instruments. International capital accords allowing institutions to set their own capital levels failed miserably, she acknowledges. "Not only did institutions claim that they could manage these new risks, they also argued that often the combination of diversification and advanced risk management practices would allow them to operate with markedly lower capital buffers than were necessary in smaller, less-­sophisticated institutions," Bair said. "In hindsight, it is now clear that the international regulatory community over-estimated the risk mitigation benefits of diversification and risk management."

The recent debacle also shows that the supposed benefits of financial diversification and scale of large financial conglomerates were nonexistent. Those factors were the ostensible rationale for the Gramm-Leach-Bliley Act of 1999, which allows financial institutions to offer a mix of banking, insurance and securities services rather than choose one line of business.

Risk diversification practices also failed to protect companies, Bair said. "The academic evidence suggests that benefits from economies of scale are exhausted at levels far below the size of today's largest financial institutions," she said. "There also are practical limits on an institution's ability to diversify risk using securitization, structured financial products and derivatives. The ability to diversify risk is diminished as market concentration rises and institutions become larger and more complex."

Bair spelled out some ideas for how a resolution authority might work to prevent panic from spreading through the financial system in the wake of a major institution's failure.

"Financial firms that rely on market funding can see it dry up overnight," she said. Consequently, they are more vulnerable to sudden market runs because of the resulting escalation of collateral demands and collateral dumping after they fail. "This can become a self-fulfilling prophecy -- and mimics the depositor runs of the past," she said.

The system should be able to carry on without breaking down after a major failure, she insists. She wants not only to see the government force riskier financial firms to maintain larger capital and liquidity buffers, but also for it to reduce derivative counterparties' incentive to force companies into failure. For instance, credit default swap holders could be forced to take up to a 20% haircut on their secured claims if taxpayers or a resolution fund face losses from a failed firm.

Gary Stern, president of the Federal Reserve Bank of Minneapolis, was ahead of the curve predicting the current crisis. Alarmed by the rapidly increasing market share held by the country's largest banks, Stern and Ron Feldman, the Minneapolis Fed's vice president for supervision, in 2003 began speaking out at conferences and writing journal articles warning of the risks festering in the system.

Even after the crisis abates, Stern does not see regulators stepping back from their desire to prop up the biggest institutions. "Policymakers understand that protecting creditors reduces market discipline," Stern says. "But they judge the costs of such a reduction to be smaller than the fallout from the collapse of a major institution."

Because he believes breaking up large firms is politically and legally impossible, Stern, like Bair, favors tighter regulation of complex firms. "Efforts to break up the firms would result in a focus on a very small number of institutions, thereby leaving many systemically important firms as is." He also says smaller firms could take on risks that pose a spillover threat.

Instead of forcing firms to get smaller, he says FDIC insurance premiums should include extra charges for spillover-related threats.

He also would maintain the prohibition banning bank mergers that break the 10% national cap on deposits. Finally, he would modify the merger review process to better allow regulators to guard against systemic risks.

A group of economists have suggested creating a type of debt instrument to cushion big institutions against hard times. The Squam Lake Working Group on Financial Regulation, which includes Baily and more than a dozen other academics, proposed that systemically important financial institutions be required to issue a long-term instrument that converts debt to equity during a crisis. If triggered, the debt would automatically convert to equity and would transform an undercapitalized or insolvent institution into a well-capitalized one at no cost to taxpayers.

"Because these contingent capital arrangements will be contracted in good times when the chances of a downturn seem remote, they will be relatively cheap compared to raising new capital in the midst of a recession," says Raghuram Rajan, a University of Chicago economist and another member of the Squam Lake group.

All this talk about higher capital standards and tougher oversight of risk management is nice, counters Galbraith, but if regulators will not insist on smaller institutions, they must at least extinguish products and business models that counter the aim of the banking system, which is to provide credit for a functioning economy.

Products like credit default swaps, which speculators have used as leverage to drive stock prices down, should be banned, he says, arguing that swaps have provided creditors with little meaningful protection against default. "They subvert the insurance function and eliminate incentive to conduct due diligence," he argues. "The financial world got along just fine without them until a decade ago. It can get along without them again."

If financial conglomerates are to remain, there must be a change in mindset among traders and executives who oversee them, he says.

"Money center banks are a problem to the extent that their main businesses are international, regulatory and tax arbitrage," Galbraith says, arguing there is no justification for that. "We need financial markets dominated by people who have an interest in maintaining businesses as going concerns."