Barack Obama is finally taking on Wall Street, apparently prompted to action by the voters of Massachusetts. But he’s taking the wrong approach.

There are hundreds of competing ideas on how to stop the banks needing trillion-dollar bail-outs. Obama has chosen three, but they are the wrong three:

1. No proprietary trading
2. No owning or “sponsoring” hedge funds or private equity
3. A cap on size for deposit-taking banks

This is not to defend the banks: they made some stupid decisions, helped out by an unending appetite for cheap debt from consumers and a global debt bubble created by China’s surplus, America’s over-consumption and Alan Greenspan’s Federal Reserve. It is right that the banks should be reformed, to prevent future bail-outs.

But these actions fail to get to the root of the problem. The banks had acted just like any other borrower when presented with cheap debt (and dumb regulators): they borrowed as much as they could (often leaving them an astonishing 50 times geared), and found ways to use it from which they thought they could make money. Lenders to the (big) banks exercised no control, because they thought – correctly – that they would be bailed out if the banks failed.

The best way to fix this problem is to find a way to allow the banks to fail. If this can be put in place, the market will itself control the banks, by increasing their cost of borrowing when they take bigger risks (more transparency may be required). If investors fail to control the banks they invest in, the bank can be left to go bankrupt – as smaller banks already do. Bondholders would lose the bulk of their money, as their bonds convert into equity, either by making all (or perhaps just most) bonds explicitly convertible, or through laws requiring conversion if a bank fails.