Treasury Secretary Timothy Geithner and Federal Reserve Chairman Ben Bernanke, along with their subordinates, frequently take credit for stabilizing the U.S. financial system after last year's panic. But whether that stability in its current incarnation is such a good thing is an open question. These same officials acknowledge that the economy is far from healthy and restoration to full health is a long way off.

"We still have a way to go before complete recovery takes hold, but we have stepped back from the brink," Herb Allison, the head of the Treasury Department's Troubled Asset Relief Program told his program's Congressional Oversight Panel last week.

The nation's lenders may now be safe from imminent collapse, thanks to the trillions of federal dollars committed through TARP and other federal lending and liquidity programs. But still they are in no position to jump-start the economy with new lending. To the extent the country's major financial institutions are making money, the profits come from the securities trading desks that brought them to the brink of catastrophe. New lending remains dead calm.

Last year's measures to stop the panic appear to have been the easy part of Washington's response to the financial crisis. The next steps -- figuring out how to get the largest institutions lending and to ensure they don't put the economy at such risk again -- are proving much more difficult. Critics of the government's efforts complain that the process is being driven too much by politics and too little by a frank assessment of the problems still facing these institutions.

Third-quarter results posted in the past few weeks showed Wells Fargo & Co. and Citigroup Inc. continuing to struggle with their loan portfolios. Morgan Stanley and J.P. Morgan Chase & Co. relied on their trading operations to mitigate the effects of higher loan losses. "We're not out of the woods by any stretch," says Tower Group Inc. analyst Jim Eckenrode. "We may have avoided the death of the industry, but I don't think things are really going to get better in the next half-year. High unemployment will have an impact not only on consumers but also on commercial debt."

Treasury chiefs say the keys to a real turnaround in banking will be efforts to shore up other sectors. Emphasizing Treasury's efforts to promote modification of troubled mortgages and assist struggling community banks, Allison said, "Sustained recovery of our housing market and of small businesses is critical to lasting financial stability and promoting a broad economic recovery."

But stability may not be the cure for an economy that's dead in the water. With the panic of 2008 behind us, many critics of the Treasury approach warn that the problems created by last year's bailout are now being compounded by new programs that will funnel money to borrowers and smaller institutions.

Modifying troubled mortgages and injecting capital to prop up the weakest of the community banks may win political points with Americans angered by the bonanza provided to big institutions but will do little to solve the larger problem of lack of credit and crippling debt in the system. Those debilitating problems won't be solved until the largest banks, which now comprise more than half the assets in the banking system, clean up their balance sheets and are in a position to extend credit in a significant way.

So far, Washington has provided the industry with injections of taxpayer money to stabilize banks, but treatments addressing the cause of the illness have been timid. Geithner and Bernanke favor doing away with the housing-focused thrift charter. They want derivatives traded openly on exchanges and a new agency to make sure predatory credit practices are curtailed. Congress appears ready to oblige.

Former Fed Chairman Paul Volcker, now head of the Obama administration's Economic Advisory Board, has repeatedly said that banks need to be prohibited from owning and trading risky securities, a prohibition that would reinstate a form of the Glass-Steagall prohibition on depository institutions that were removed in 1999. In the European Union, such a move appears to be under way already, if haphazardly. On Oct. 27, Dutch financial conglomerate ING Groep NV unveiled a breakup plan negotiated with the European Commission and Dutch regulators over the past six months because of infusions from government regulators to stay afloat.

Christopher Whalen, managing director of Lord Whalen LLC, also believes in such get-tough remedies. He says that what is needed to put U.S. banks on sound footing again is the will to finally impose losses on financial institutions' creditors -- bondholders, primarily -- and free up large institutions' cash for more lending. Longer-term, regulators must decide which activities large lending institutions will be allowed to engage in.

"Citigroup had $20 billion in revenue in the third quarter; that's not enough," says Whalen, who has called for the government to force Citi and struggling financial institutions' debtholders to accept reduced payments in return for an equity stake.

"With Citi, if you reduce its debt obligations by one-third, you'd be done," Whalen says. "You'd have the most liquid bank in the U.S. the next day." Whalen blames foreign debtholders such as China and large investment funds such as Pacific Investment Management Co. LLC and BlackRock Inc. for opposing the idea. "We've been subsidizing debtholders the whole time because none of these guys want to take a loss."

Tower's Eckenrode agrees that banks' finances are a problem but thinks debt convertibility is a remote possibility now that the crisis has passed. He's less pessimistic than Whalen about the industry's ability to work out its problems without further turmoil. He also disagrees that the industry must get smaller. The two analysts' differences are emblematic of the split among experts on how to get banks healthy again and how sick they actually are.

"I hear a lot less about convertibility or nationalization of assets now that things seem to have calmed down," Eckenrode says. Instead, the likely scenario is for economic revival to wait until banks have worked through problem loans. "Charge-offs are increasing, nonperforming loan levels are starting to drop and banks are busy moving bad loans off books."

Whalen predicts another panic may not be far off. Bank valuations remain artificially high and eventually will correct, regardless of government intervention. "Solvency is an issue for next year," Whalen says. "The conversation will change next year, when it becomes clear how much deflation we will still have in the system. We're going to get down to $11 trillion in banking assets by the end of next year -- that's scary. We were at $13 trillion at the end of 2008."

Whalen points out that the over-valuation problem goes far beyond mortgages. Because of commercial loan forbearance, banks have ignored corporate borrowers' increasingly desperate straits. "Accounts receivable data is terrifying," he says. "Once it stood at 4 times the bank lending book. Now it's cash on delivery." But banks don't want to shut borrowers down because there's nobody willing to acquire their assets.

In crafting a long-term response to the financial collapse, Washington mostly has nibbled at the periphery rather than addressing the core problems posed by gigantic institutions, says Joshua Rosner, managing director at New York investment research firm Graham Fisher & Co. Imposing higher capital requirements on their trading operations, or threatening to take part of a large firm after an economy-threatening failure, as the Obama administration's plan seeks, won't prevent a future catastrophe, he says.

"Everything Congress and the regulators have been doing is more focused on minutiae," says Rosner. Washington's top priority should be ensuring that today's too-big-to-fail institutions break up or shrink so that they no longer pose a threat. "It's the first thing that needs to be done, not the last thing. Tackling that would shape all other aspects of the financial reform package."

For the most part, regulators have proposed little more than raising capital requirements on large institutions, particularly for trading and other riskier operations. "There's this Kabuki going on where we are talking capital; meanwhile, nobody is talking about what activities the banks will be allowed to engage in," says Whalen.

Insistence that institutions no longer be permitted to grow so large that they pose systemic threats is delusional and has distracted from more realistic safeguards government can impose, says Eckenrode. "The model we've seen in the developed world is for less than a half-dozen banks controlling 50% of the marketplace. That horse has left the barn, and I don't see banks getting smaller."

But limiting their activities will be a nearly impossible call, too, he says. The new rules on consumer lending, such as limits on overdrafts and changes to credit card fees, will ensure that banks will look for ways to offset the new constraints on their profits.

Thomas Vartanian, partner in the Washington office of Fried, Frank, Harris, Shriver & Jacobson LLP, is also skeptical that banks will get smaller. "What to do about banks that are too big to fail has been debated for the last 30 to 40 years. The problem is that nobody has figured out how to have banks that are competitors in the global marketplace and not have institutions that are too big to fail."