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WASHINGTON (MarketWatch) -- What do you do with "too-big-to-fail" banks when you don't want to bail them out, but you don't want to break them up?

That's the dilemma members of Congress who are working furiously to create a process that would let a behemoth financial institution collapse in a way that avoids a repeat of the collateral damage to the markets that occurred when Lehman Brothers imploded last year.

"The problem you have right now in a crisis is that the choice you have is bankruptcy, like with Lehman -- where nobody gets paid -- or no bankruptcy, like with AIG -- where everyone gets paid," said Rep. Barney Frank, D-Mass., chairman of the House Financial Services Committee and drafter of legislation designed to prevent a repetition. "This would create another way."

The goal is something everyone can agree on, but the bill as it is written would create a hodgepodge of unintended consequences, with more expected as policymakers morph it into something they can approve.

It also raises more questions than it answers: How much taxpayer money would be on the hook? How much would banks pay into a newly proposed insurance fund? Which institutions would be dubbed, "too-big-to-fail"?

The bill would create a council of regulators, including the Treasury Department, current federal and state bank regulators and the Securities and Exchange Commission that would have broad authority to oversee and influence how much capital each big bank must carry on its books.

Faced with a large bank on the verge of insolvency, the group could wipe out the bank's management and take steps to dismantle it in a way that policymakers hope won't stress the markets. See full story.

To do that, the government would provide funds to creditors, debtholders and counterparties of the failed bank so they don't collapse as well. Those investors would be required to take some losses, but the government would make sure their losses weren't so severe that they also would disintegrate.

Large banks with at least $10 billion in assets would be required to pay fees in advance into a special insurance fund that would cover payments needed to safely dismantle an insolvent too-big-to-fail bank. Roughly 120 banks would be responsible to cover the costs had the fund been in existence today.

If the insurance fund didn't have enough capital to cover the costs, the measure would allow Treasury to lend taxpayer money to cover the costs, with an assumption that the amount would be recouped later by assessments on big banks.

Frank's Senate counterpart, Sen. Christopher Dodd, D-Conn., the chairman of the Senate Banking Committee, is expected to release details about his systemic-risk legislation in the coming week. While Dodd and Frank disagree about some aspects of bank reform regulation, both generally agree about the mechanics of a mechanism to dismantle a large financial institution in the case of a financial crisis.

Who gets on the lifeboat?

Treasury Secretary Tim Geithner envisions that the authority could be used to stabilize the markets in a scenario where one large insolvent bank would be dismantled with the process, while the Federal Reserve makes capital injections to stabilize healthier banks and the rest of the industry.

"You need to be able to take down one institution, but make sure the rest of the system remains stable," Geithner argued.

However, critics argue that future financial crises won't be as simple as identifying the one bad bank and collapsing it in such a way that it doesn't hamper healthy banks. Brookings Institute fellow Douglas Elliott contends that in an economic crisis there will be a number of institutions that all start tottering at the same time and it will be difficult to separate the healthy from the sick.

"It's hard to know for sure during a crisis whether a troubled institution is solvent or not solvent," Elliott said. "There will be triage where you say, 'These guys will live, we're not going to do anything; these guys will die, we can't do anything; and these guys are troubled but will make it with our help.' "

Bigger would be better

Observers complain that the proposed payouts would drive investors to push capital to the largest banks on the belief that they will be bailed out, or at least partially bailed out, should they collapse.

The provision would result in massive inequities for smaller banks, argues Rep. Brad Sherman, D-Calif., a senior member of the House Financial Services Committee and an outspoken critic of the Frank bill. He argues that smaller institutions would be hurt twice.

First, Sherman contends that potential investors are more likely to invest capital into the bigger banks rather than smaller ones because of the bail-out protection. Second, he says healthy, mid-sized institutions with $10 billion in assets or more would be paying to cover the costs of a major collapse, even though their failure would never warrant a government payout because their implosions wouldn't be considered systemic enough.

Rep. Randy Neugebauer, R-Texas, argues that smaller banks couldn't compete with their systemic rivals who would have triple-A credit. " 'I want to be on the systemically risky list', they tell me because that makes my credit golden," he said.

However, Jonathan Arnold, an economist at the Analysis Group in Chicago, argues that larger financial institutions add value to the economy as a whole and their collapse would hurt smaller banks as well.

"Small banks benefit and their payments mean the economy won't dive into a tailspin," Arnold said.

He points out that the Frank bill also seeks to impose greater capital standards and liquidity limits and even possible constraints on concentrations in certain activities on larger systemic institutions, which could give their smaller, more flexible rivals a competitive edge.

Analysts can't figure it out

Nevertheless, Sherman argues that a government program that provides taxpayer funds to creditors of an insolvent super-bank would be difficult to administer by the Federal Deposit Insurance Corp., the government agency charged with that responsibility.

Backers of the legislation point out repeatedly that an insolvent bank's counterparties won't be completely bailed out, that they would need to take some losses. The administration is seeking to avoid the widely criticized approach it took where counterparties of American International Group Inc. in the U.S. and Europe were bailed out fully with U.S. taxpayer dollars. But how would the payouts be administered?

"If the goal is financial stability, how would the FDIC identify how much to give to each institution to keep each one solvent?" asked Sherman. "If there were four banks that are all owed $1 billion by a failing Goldman Sachs, are we going to have each creditor treated differently depending on how strong they are?"

How to recoup when times are good?

Brookings' Elliott said it made sense for fees to be collected up front from large financial institutions to pay for the fund. However, he argued that in the event of a future crisis, it was likely that taxpayer funds would need to be employed to dismantle an institution. The prospects for recouping those funds from the industry would be difficult, he added.

"During difficult economic times, it's hard to recover the money because policymakers don't want to hamper financial institutions," he said. "However, during good times, it becomes politically hard to recoup the funds because the situation is so far in the past."

He also contends that politically, it would be difficult for the bill's envisioned council of regulators -- and their varying interests -- to take vital so-called countercyclical steps during a boom period to limit the damage during the next major downturn.

"My biggest concern is it is politically, really hard to move against a bubble," Elliott said. "During good economic times, can you imagine a regulator requiring a financial institution to ask for bigger down payments on homes?"

Cap taxpayer exposure?

The legislation also seeks to limit how much can be spent by the Fed and Treasury to dismantle a super-bank. Geithner indicated in testimony before Congress that he may back such an approach. Legislators are expected to propose limits on the amount of taxpayer capital that can be spent in a crisis.

Other checks and balances are being crafted. Frank is working on a measure that would require congressional approval before the central bank could provide assistance to healthy financial institutions during a financial crisis.

All this has Arnold of the Analyst Group concerned that lawmakers could be going too far in constraining the central bank's ability to intervene in a timely manner and that Congress would be getting too immersed in the decision-making of banking operations.

"It is a mistake to get Congress involved," he said. "It invests political considerations when politics should be out of the picture and rigorous economic analysis should be in."