As the financial system begins to recover, it becomes clearer that two issues that need to be addressed by policymakers are the improvements to the regulatory mechanism and the shape of the financial system itself. The two issues are linked, and both are formidable.

While much has been written and debated about the best regulatory mechanism for finance, there is surprisingly little discussion about the shape of the industry. Partly no doubt this is because over the last several decades many of these "decisions" have seemingly been left to the market to resolve. Policy was seen as an unwelcome intrusion into the smooth functioning of markets.

However, the debacle of the past several months has fundamentally, and perhaps permanently, altered that dynamic. The reality of the crisis itself has brought government squarely into the act. Just think of the government actions that have taken place since August 2007. They include a massive opening of the discount window; equity investments by the government in large financial companies; a huge expansion in deposit insurance; FDIC guarantees on banks' senior debt issuances; and nationalization of the housing government-sponsored enterprises and the largest U.S. insurance company. The purchase of troubled assets by public-private partnerships is coming next.

Clearly, the public has lost a great deal of faith in the unbridled marketplace, particularly for finance. News reports about derivatives, failing institutions and incidents like the Madoff affair have created the conditions for a rethinking of the shape of finance in America.

Accordingly, the shape of the financial system is very much in the hands of policymakers. And, their decisions — including, importantly, the shape of the regulatory system — will tell the tale in terms of what kind of financial services system we have.

Currently there is a tilt in the system toward the "too big to fail" institutions. It may well be that we are trending toward a financial system like that of France or the United Kingdom where smaller, community-based institutions are almost nonexistent. I personally think this is a big mistake, but if we have a system that props up the largest and fails the smaller firms, that is the destination of the locomotive at this time.

For the "too big to fail" institutions, the danger is that the designation effectively vests them with characteristics of wards of the state, and makes them a species of public utilities with limited activities, larger capital charges and limits on compensation. Their loss of autonomy could be the next tier's gain: The dividing line between the "too big to fail" and the category just below them could result in superprofitable, midsize trading institutions with a competitive edge over the larger ones.

Another plausible scenario is that the "too big to fail" larger institutions could be winnowed down to four to six, from 19. Whether determined by market forces or the government, if some institutions cannot over time exist without direct government support and others can, this is likely to result in some form of resolution or forced government consolidation.

If we are to maintain a vigorous set of large and smaller financial institutions consistent with a dynamic marketplace, certain issues must be sorted out. Let me suggest several of those issues and provide a few thoughts as to each.

First, we must have a level playing field for all institutions. This level playing field relates to all manner of government involvement, be it tax, regulation or disguised subsidies through monetary policy and other tools. We can't have more onerous regulation for some but not for their competitors. Some players cannot have small capital charges or scant regulation and compete with banks or insurance companies that operate under a more exacting regulatory regime. Similarly, we can't decide to fail hundreds of small banks while the government props up their competitors or otherwise gives these competitors a more felicitous regulatory regime.

Second, we have to come to grips with whether we want deposit caps or any other caps on larger institutions. Artificial government-imposed marketplace limitations such as these tend to cause enterprises to engage in noncore activities to grow elsewhere, and these activities may be less safe than expanding in their core businesses. On the other hand, unless the regulatory playing field is leveled, withdrawing the caps might well lead to a wholly concentrated banking system, where "too big to fail" takes on greater dimensions.

Third, we have to have a clearer understanding of how we want to deal with the issue of monoline versus diversified institutions. Smaller institutions by their nature are less diversified than larger institutions. Specialization often means better customer service and risk mitigation through superior knowledge of the marketplace. It may also mean a better opportunity to assist innovation and new businesses. On the other hand, a severe tail event in one financial sector can be life-threatening to a monoline.

Fourth, regulatory excellence benefits financial institutions just as regulatory excess does not. Any new system of regulation has to ensure that regulated institutions are not just on a level playing field as to rules, but also as to who does the regulating and how.

Sorting out these issues before we jump into a new regulatory framework is of considerable importance to the well-being not just of different segments of our financial services industry, but ultimately of the different segments of our economy that rely on diversification of financial services providers.

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