By William M. Isaac and Cornelius Hurley, Published by Forbes

The severe public backlash against the serial taxpayer bailouts of financial behemoths under the ill-conceived TARP legislation, coupled with a potentially momentous congressional election this fall, has politicians falling all over each other in their zeal to be seen as slaying the “too big to fail” (TBTF) beast “once and for all.”

Some Democrats would create a $50 billion to $150 billion slush fund to resolve future TBTF failures, while others propose breaking up the large banks. Republicans would emasculate the authority of the Federal Reserve and Federal Deposit Insurance Corp. to intervene and calm a future crisis before it gets out of hand. God help us in the next crisis, because the Fed and FDIC will not be allowed to do so.

The truth is that the government cannot allow our five largest banks to topple when they collectively control more than half the financial system. It would result in economic collapse.

The slush fund carries the risk of being misused and spreading the moral hazard of TBTF. As for break-ups, the rhetoric is surely present, but the will to do so is absent even if someone could figure out how to do it without emasculating our financial system. Stripping the Fed and FDIC of their intervention powers almost guarantees the next crisis will spiral out of control, forcing Congress to create “Son of TARP.”

But there is a bold market solution that all sides can embrace. It requires Congress to pause long enough in its scramble for partisan advantage in the fall elections to consider something that will actually work. This solution balances the two pillars of democratic capitalism: regulation and market discipline. It places the ultimate fate of TBTF firms in the hands of their shareholders, while protecting the financial system and the public Treasury from the contagion effects of future TBTF meltdowns.

First, identify the handful of TBTF institutions. Largely the regulators, the credit rating agencies and crisis-induced consolidation have already done this (Goldman Sachs, JPMorgan Chase, UBS, etc.).

Second, require each TBTF firm to establish a separate reserve account on its balance sheet consisting of some or all of the annual taxpayer subsidy it enjoys as a result of its privileged status (we call it a “subsidy reserve”). Treated as capital for liquidation purposes but not for regulatory purposes, the subsidy reserve would be easily calculated based on the “support” vs. “stand-alone” ratings currently assigned by credit rating agencies.

Third, require that the subsidy reserve accumulate indefinitely, including the earnings on the reserve.

Fourth, provide that the subsidy reserve can be transferred to shareholders or others only in the form of spin-offs of companies or divisions; it cannot be paid out in the form of dividends. In other words, the only way the value of the subsidy reserve can be unlocked is through downsizing the firm. In relatively short order the TBTF firms will be carrying very large reserves, which will be available for use only in the event of a firm’s failure.

The accumulation of reserves, combined with higher capital and liquidity requirements imposed by regulators, would lead to shareholder demands that such reserves be more efficiently utilized. Managements and boards of directors would have two choices.

They could continue business as usual, in which case the subsidy reserve plus capital would accrete to the point where the firms actually become “too safe to fail.” This will be reassuring for taxpayers but will result in relatively low returns on investment for shareholders.

The more rational management response will be to shrink by divesting subsidiaries or spinning off divisions to shareholders. In this process, the subsidy reserve will be allocated to the newly divested entities. Divest enough and the firms are no longer TBTF and are no longer required to post the subsidy reserve.

Among the pernicious effects of TBTF is the ongoing wealth transfer from taxpayers to the TBTF firms. The TBTF discount distorts the capital markets, artificially dividing the markets into TBTF firms and all others.

The shareholder-driven approach we are proposing is one that politicians and bankers of all stripes can get behind. It is self-policing, and it can be readily adopted on a global basis.

Particularly if coupled with substantial regulatory reforms and restructuring, which unfortunately are not included in the current legislative drafts, the subsidy reserve will bring an end to distortions caused by TBTF. Best of all, it will be the markets, not central planning in Washington, that determine the winners and losers.

William M. Isaac, chairman of LECG Global Financial Services, was chairman of the Federal Deposit Insurance Corp. during the banking and S&L crises of the 1980s. He is the author of Senseless Panic: How Washington Failed America.

Professor Cornelius Hurley, director of the Morin Center for Banking and Financial Law at Boston University, was assistant general counsel at the Federal Reserve Board during the 1980s.