I don't know that you need to regulate compensation. You just need to not bail them out when they blow up, and it will self-correct. And you shouldn't let them gamble with federally insured (FDIC) money - either be a investment bank or a commercial bank, but not both, so that regular consumers don't get caught in the middle.

I totally agree. Had everyone been allowed to fail, we would've been well on the way to recovery already. It's frustrating to watch the government keep this pathetic lifeline going which will fail in the end anyway.

But isn’t this scenario impractical for reasons shown by the current problems in Europe? On Cyprus, the banks were considered “too big to fail”, meaning that they would take the whole economy with them if they went down.

Cyprus is not a good case study - the banks there actually are the whole economy, to some degree. Aside from tourism, they were supporting themselves by banking a lot the money coming of Russia, etc. The assets of Cypriot banks were ~9X their GDP, and the size of the estimated bailout was about 1X GDP.

If you don't let big banks fail, then nobody ever has to worry about counterparty risk, and they won't keep an eye on each other to see if one bank is taking too much risk or backing too many bets.

This is known as a partnership, where the partners' personal assets are at risk. This is what the investment banks used to be, way back when. (Consulting firms too, for that matter)

If I had some sort of magical power to enact this kind of reversal to where ibanks were once again partnerships, I'd do it in a heartbeat.