NEW YORK (Fortune) -- The Obama administration has promised to fix big financial firms with a helping of "tough love." But even stronger medicine -- such as breaking up troubled banks and starting new ones -- may be necessary.

Treasury Secretary Tim Geithner said Tuesday that the administration seeks to restore the flow of credit in the economy by offering $1 trillion in financing for consumer and business loans, a $500 billion plan to induce private investors to buy troubled assets from banks and $50 billion for foreclosure relief.

But some investors and economists are urging policymakers not to pour more scarce resources into troubled banks that are still run by the executives who got them into trouble in the first place.

Instead, they say, the government -- confronting a deteriorating economy and a cast of financial executives that's largely unchanged despite the near collapse of their industry -- should be setting up incentives to create a healthier and more sustainable financial system down the road.

That means finding a way to cut the too-big-to-fail crowd down to size.

"Without a tough government-imposed framework, intervention on this scale will be hard for people to swallow," said Richard Ferlauto, director of corporate governance and pension investment at AFSCME, the biggest U.S. public worker union. "They're going to need to be quite tough."

Buy common stock and start swinging the ax

The key to devising a workable financial rescue plan, economists say, is to draw in new capital for troubled banks while creating incentives for their investors to exert real control over management.

This can be done by forcing troubled firms to attempt to raise capital in the markets, including from their existing owners. If the banks aren't successful in doing so, the government should pour in new capital while taking appropriate compensation -- in common stock rather than preferred, for instance -- that would then be sold off as soon as is practical.

Ross Levine, an economics professor at Brown University, said if the government starts buying common stock in banks, it will show that it is serious about taking control of troubled institutions and protecting the taxpayer.

"If you go refilling the bank accounts of the architects of this crisis, people are going to have an emotional reaction," said Levine. "You can't make the recovery plan a direct gift to the existing owners and managers of these enterprises."

If the government actually owned common stock in banks, it would allow regulators to have more of a say in how the banks are managed going forward.

That could make it easier to break up the big banks, which some experts think makes sense.

The near collapse over the past year of Citigroup (C, Fortune 500) and Bank of America (BAC, Fortune 500) shows that the so-called financial supermarket model doesn't work for anyone but executives, Ferlauto said.

Shareholders, bank customers and taxpayers have all been short-changed in the creation of these dysfunctional institutions, he said. Shares of Citi and BofA are trading near their levels of two decades ago despite receiving of some $400 billion in government support.

"You need to find a way to break these banks into pieces with a business focus," said Ferlauto. "You need to find a way to get retail banking going again."

New banks needed to kick start lending again

Forcing big banks to downsize may not be enough to end the crisis, though. Some think that the scope of the problems confronting all the big U.S. financial firms -- including healthier banks like JPMorgan Chase (JPM, Fortune 500) and Wells Fargo (WFC, Fortune 500) -- will make it more difficult for Geithner's bank rescue effort to work.

With the economy expected to weaken further this year, more heavily indebted companies will probably be forced into default. Falling home prices and rising unemployment will also likely lead to increased losses in banks' mortgage and credit card portfolios.

"The banks are impaired by declining asset prices, particularly in real estate, and that isn't going to change any time soon," said Igor Lotsvin, who runs Soma Asset Management in San Francisco. "The solvency problems are only going to get worse, because delinquencies in a number of asset classes are going to rise sharply this year."

With this in mind, Lotsvin and partner David Chu, whose Soma Isosceles fund returned 34% in 2008 thanks in part to successful short bets against big bank stocks, said there's a need to start new banks to lend in the place of the troubled existing firms.

They aren't alone in advocating that concept: Paul Romer, an economist at the Stanford Institute for Economic Policy Research, wrote in an op-ed piece last week in the Wall Street Journal that the government could support $3.5 trillion in new lending capacity by using the remaining TARP funds to seed new banks instead of fixing the old ones.

Not everyone is sold on this notion, though. Levine called the idea "impractical," saying banks are repositories of information and business connections as well as conduits for money.

"These institutions -- even the troubled ones -- are immensely valuable to society," Levine said. "Trying to go around them won't work."

Nonetheless, the debate highlights what Geithner and his colleagues most certainly realize: the banking problem won't be fixed quickly.

"There are no obvious decisions here," said Chu. "No one is saying this is going to be easy."



