The failure of Lehman Brothers last year froze the global financial system, causing the government to bail out every major bank on Wall Street (directly or indirectly). Since then, the looming question has been: How do we deal with banks that are “too big to fail”? What should we do with banks that are so large that they would destroy the financial system if they were allowed to go under?

Since the crisis, our biggest banks have only gotten bigger. My colleagues Ilan Moscovitz and Morgan Housel recently wrote a piece on ending “too big to fail” in which they pointed out that out of 8,195 banks in the country, four -- JPMorgan Chase (NYSE:JPM), Citigroup (NYSE:C), Wells Fargo (NYSE:WFC), and Bank of America (NYSE:BAC) -- control almost 40% of the nation’s deposits.

Enter Congressman Paul Kanjorski (D-Penn.), chairman of the House Financial Services subcommittee on capital markets. He has come up with a solution to deal with entities that are “too big to fail” -- a bill that will allow regulators to preemptively break up large financial institutions based on certain metrics, including amount of assets held, reliance on short-term funding, leverage, and interconnectedness within the system.

In an interview, Rep. Kanjorski talked with me about his proposed legislation and creating a safer financial system. Here is an edited transcript of our conversation:

Jennifer Schonberger: Congressman, I understand you have just passed an amendment to the systemic risk legislation [Financial Stability Improvement Act] in the House Financial Services Committee that would give the government authority to preemptively break up large financial corporations to prevent them from becoming “too big to fail.” Tell me about how the amendment would work.

Rep. Paul Kanjorski: As of last September, the only choice we had as far as authority of the regulators [over financial institutions] was to let them follow normal procedure. That is, they could file for bankruptcy and go into receivership.

[But given what happened last fall] ... we [said we] need something before bankruptcy, and that became known as resolution authority. That’s what this underlying bill is all about.

We’re saying, at the time when you would be able to go into bankruptcy -- that means you’re defaulting, you’re in extremis -- you can go another route, called resolution authority. It’s a highly managed situation where the assets can be properly managed -- held, sold, spun off, etc. But that situation only happens when you’re in extremis. ...

It became clear that rather than ... put other institutions and the whole system at risk, we can do it preemptively ...

The whole theory of systemic risk is, we need a regulator that analyzes which companies in our system -- particularly financial institutions -- are of such a nature that either they’re so large or interconnected, or have such a scope of operations, that they could cause a cascading effect to put the financial system in questionable stability or destroy the entire economic system.

In order to prevent that, the easiest thing to do is to run a test in which we identify the top 50 riskiest institutions. Preemptively, we set up a standard, a due process hearing and a methodology to do many things, with divestiture or sales being the last step. Before that, we’d say, "You're at risk."

When you identify that one of those institutions falls into the category of these various classifications, then if we took preemptive strike authority, maybe we can save some of these institutions and show them a new way.

If it were AIG (NYSE:AIG), we’d say “You can’t engage in derivatives anymore, you’re putting everything in your company at risk.”

Schonberger: Is it the proposed Financial Services Oversight Council that would oversee and have authority to break up these institutions?

Kanjorski: Yes. It’s the council of regulators, or the nine members of all the regulator authorities and people that are identified in the underlying bill. Even though they really are a “superregulator,” they’re not going to have a separate entity of regulation. They’re going to utilize the Federal Reserve as a channel.

Schonberger: I understand that the council will examine a number of criteria, including amount of assets, reliance on short-term funding, leverage, and interconnectedness within the system, to name a few. But when will they have the authority/obligation to break them up? Is there a trigger of some sort, or is this subjective?

Kanjorski: We amended my amendment slightly in committee. Rep. Mel Watt inserted a secondary amendment. We require the council to make a finding that all those conditions have gone through and none of them are workable in the circumstances before they can go to divestiture or sale.

The council and the regulator -- that is, the Federal Reserve -- are really charged with setting the standards and regulations -- that is, to come up with a year-end report to Congress on what they deem to be the 50 most systemically risky organizations in our system. By virtue of doing that, they’ll be informing the Congress of what the status of the system is -- but that will force them to exercise a regular study procedure and keep on top of these institutions and their risk profile.

Schonberger: Do you think that regulators will have the political will or capacity to break up these powerful companies during good times, if it’s so hard to get it done even after this crisis?

Kanjorski: Implementation is always an important thing. You can arm and provide all kinds of laws, rules and regulations, but they have to be properly implemented. I think they will utilize it.

Schonberger: What about the odds for passage in the full House of the three other bills [the Investor Protection Act, the Accountability and Transparency in Rating Agencies Act, and the Private Fund Investment Advisors Registration Act] you have proposed that have already passed the Financial Services Committee?

Kanjorski: I think that we’re well on track to get that done. When we get back from Thanksgiving break, we’re going to take up our fourth bill on insurance information, and that will pass, I’m sure. I’ve worked very hard to get bipartisan consensus. Three of four of my bills are very bipartisan. So that would indicate to me that they would pass on the House floor in a bipartisan way.

On the amendment and on the [Financial Stability Improvement Act] bill, I don’t think we’ll get any Republicans. Philosophically, it rubs them wrong. ... I would think we’re on our way and will pass it out of the House sometime in December.

Schonberger: If it’s risk you’re looking to eliminate from the system at large, why not reinstate a Glass-Steagall-like act, where you separate the inherently risky investment banking operations from commercial banking operations? Certainly we didn’t have these problems prior to the repeal of Glass-Steagall and the instatement of the Gramm-Leach-Bliley Act.

Kanjorski: Ten years have passed, and in that time we’ve developed a global economy of incredible proportions. The world has changed significantly. I’m one of those people who say you can’t really put the genie back in the bottle very often. We have to realize the circumstances now, and I’m pragmatic enough to say, “OK, we can deal with this, we’ll just use different tools.” This is one of the new tools we’re going to have to accept because of the global economy.

Schonberger: As you mentioned, the U.S. financial system has increasingly become a globalized system. Can legislation be effective domestically if we don’t coordinate on an international level?

Kanjorski: Along with my fellow members [of Congress] this summer, I met with the EU economic committee, the regulator in the U.K., France, and Brussels, and we came away with an expression of intent to harmonize our standards as we approach this problem so that we protect against "forum shopping."

We’re going to coordinate and standardize the regulations for the securities industry, the insurance industry, and the banking industry. We have good agreement to do that, and I think we can succeed. We’ve included those restrictions and directions within the legislation to accomplish that.

Also toward that end, we’re starting to have meetings. I’m meeting with the European parliament in December, and we’re going to hold [transatlantic] committee meetings through video on a regular basis.

We have a very common denominator that we’re after. Eighty percent of the security industry occurs either in the U.S. or in the EU. That’s going to deteriorate eventually. Some of that business is going to start going to China and Japan. If we take this opportunity over the next several years to standardize and coordinate these regulatory reforms, we’ll be able to set that standard for the next 50 to 100 years. Then China and Japan will buy into our standard. But if we lock up and don’t do that, it’s going to be a bidding game of who can find the cheapest, easiest, least regulated forum, and that will put the world in great jeopardy.

Schonberger: We recently interviewed Simon Johnson, former chief economist of the IMF, and he said the financial industry has captured the government. Wall Street historian Charles Geisst says the New York Fed is too cozy with Wall Street. What is the appropriate relationship between the government and financial markets?

Kanjorski: There isn’t an enemy relationship between government and the private sector, but on the other hand there should be a cautious arm’s-length relationship to make sure you’re not conned. But let me back up.

There is a huge political science question that we’ve faced for a number of years, and this may be part of our solution to it. The question is: Is there going to be an opportunity in the world to have major corporations grow so large that you could have all of your economic factors controlled and owned by five big corporations -- the “five big Cs”? Are they going to exceed the ability of democratic governments to deal with them and regulate them? Or are they going to be larger and more powerful and overwhelm those democratic governments?

We’re almost at the point now where we’re losing that ability to regulate these entities. We let capitalism escape from reasonable regulatory control. That’s a very serious thing, primarily because corporate structure is authoritarian and government is democratic and is much less responsive -- certainly not as dictatorial as corporations. We’re at the window of opportunity now. We [need to] get a way of controlling these megacorporations [such that they] will not rule the world at least economically, and then probably politically, because they’ll be so gigantic.

... In the meantime, our democratic institutions of government may be at risk.

What do you think would help end “too big to fail”? Chime in below!