“The moment I cross the threshold of a bank and attempt to transact business there, I become an irresponsible idiot,” lamented Stephen Leacock, the Canadian humorist. A century later and in an impossibly more complex financial system, it is obvious that in that case he was perfectly at home in the institution.

The Government is proposing reforms to the banking sector in the Queen’s Speech this week. The need for better regulation is self-evident. How to accomplish it is not. The most politically potent issue that the Government will address is bankers’ bonuses. It is important to tie bankers’ pay more closely to long-term performance, along the lines proposed at the G20 summit in September. But ultimately this is a second-order issue in financial regulation. The overriding need is to make the financial system more stable.

Two things would help. The first is to make it easier to wind up a failing bank. The second is to protect the basic retail functions of a bank – taking deposits and making loans – from more speculative activities, such as derivatives trading for the bank’s own book. These are principles that the Government and the regulators, along with their G20 counterparts, would be right to examine. The bitter recession from which the advanced industrial economies are emerging is not a crisis of capitalism. It is a result of incompetence in a dysfunctional banking system.

The credit crisis of 2007-08 is often attributed to weakness in the US housing market. That is wrong. The asset price bust in the US and UK is a symptom, not a cause. The greatest financial crisis since the 1930s was created not by mortgage borrowers but by bankers. Exploiting a huge credit bubble, they imagined that a proliferation of complex financial instruments had reduced the risks of lending. Acquiring assets whose value depended ultimately on the superstition that house prices could only ever go up, they wrecked their own balance sheets and had to be bailed out by the taxpayer at fantastic expense.

There will always be banks that fail. Governments must have a better choice between letting them go bust, as the US Treasury did with Lehman Brothers, or rescuing them hurriedly and without regard to cost. A “living will” drawn up by banks, providing financial information for regulators, is in principle a way of ensuring an orderly wind-up of a bank’s operations. It would allow the basic banking functions to continue, while ensuring that the costs were borne by shareholders rather than customers and the taxpayer.

The Government and the Financial Services Authority have held out against mandatorily separating banks’ retail operations from their riskier investment banking operations, however. A strict division is probably not practicable. Retail banks inevitably do some things, such as foreign exchange dealing, that might be either for customers’ benefit or for pure speculation. But greater transparency of banks’ risky activities is urgent. If derivatives contracts were traded solely on organised exchanges, for example, that would give regulators better information about the scope, value and risks of these instruments. Banks that took on big risks would be more visible, earlier. Human folly is limitless, and it has found a home in banks’ boardrooms. The damage that it inflicts needs to be anticipated, and mitigated.