The following is part two of a three-part interview. (Part one dealt with derivatives and the Volcker rule.) Here, Assistant Treasury Secretary Michael Barr and Motley Fool editor Ilan Moscovitz discuss how the financial reform act attacks the problems of being "too big to fail" at institutions such as Wells Fargo (NYSE: WFC), JPMorgan (NYSE: JPM), Citigroup (NYSE: C), Goldman Sachs (NYSE: GS), and Bank of America (NYSE: BAC) and regulatory failure.

Ilan Moscovitz: Some of Treasury's core objectives, things like the Financial Stability Oversight Council and tying capital requirements to systemic riskiness, are going to depend for their application on how risky to the system regulators deem particular institutions. What sort of criteria would you recommend for identifying systemically significant financial institutions?

Michael Barr: Well, in the legislation there were some key criteria that will have to be further defined by the Financial Stability Oversight Council and Treasury chairs during a process, but certainly things like size, interconnectedness, the extent of leverage in the system, the kind of firms that have high correlations and interconnectedness with tight linkages with other firms, concentration of assets, and concentration with any financial sector. All those factors and others will be important for examining risk in the system.

Moscovitz: I like to think of the act as much a regulatory overhaul as much as an overhaul of Wall Street, so there's a thought experiment I want to consider: Assume that at some point in the future we end up with a crop of regulators, like the previous ones, who fundamentally just don't believe in regulation. Are there some key reforms that you think would still function really well to contain excessive risk taking? And do you think that those would be enough to prevent a future crisis?  

Barr: I think that in our set of reforms, we had to take into account two things: One is that we know that regulators are going to fail in the future, and two is that financial managers are going to fail in the future.

We didn't want to build a regulatory system that was based on some idea that people in the future are going to be smarter and better and more committed in the future than they were in the past, so the system that we wanted to set up was based on humility about the ability of institutions and of people to act.

At the same time, we wanted to set up the system that wasn't so rigid, that the financial system would innovate their way around it and end up evading the basic restrictions, you are causing problems in the future the way Fannie Mae and Freddie Mac frankly did with their capital requirements that were put into their statutes. We had to balance those two things.

I think the bill overall moves somewhat away from regulatory discretion, builds in somewhat harder rules such as the 10% liability cap [Editor's Note: Subject to a council study and certain exemptions the Fed may grant, the act bans mergers and acquisitions that would result in concentrating more than 10 percent of total financial industry liabilities in a single bank], the restrictions on management interlocks, and the like. The restrictions in the Volcker rule, the capital requirements that we have been pushing on internationally for the last year and a half that will be higher, more robust, better quality, less pro-cyclical in the future, all of those will, I think, build these better guardrails into the system, but at the end of the day, you are not going to be able to 100% prevent stupidity, banality, and failure.

Moscovitz: Absolutely. Is there anything that is being done to improve the odds that we can get the best regulators in the future, perhaps higher and more incentive-based compensation or longer lock-out periods to move to the industry after the job, or is this basically something that will always have to depend on voters to choose a president who will appoint the right agency leadership?

Barr: I do think making sure we have good, strong accountability at the top is really important in terms of picking people. I have to think the bill does take a number of steps to improve transparency in the system so that regulators can more readily be held accountable for their activities, but at the end of the day, finding and retaining good people and making sure they are doing the best job possible is critical for regulators and for financial institutions, too.

Tune in to tomorrow for part three of this three-part interview.

Motley Fool editor Ilan Moscovitz doesn't own shares of any company mentioned. The Fool has a disclosure policy.