Taxing the financial transactions carried out by the banks could help to prevent excessive bonuses, the boss of the City watchdog claims.
Lord Adair Turner, chairman of the Financial Services Authority (FSA), says the City has grown to be too big and accounts for too much of the country's output while luring too many of the brightest graduates with its rich rewards.
With its excessively big profits, the City had "swollen beyond its socially useful size", he added at a roundtable event organised by Prospect magazine.
Turner suggested that areas including fixed income securities, derivatives, trading and hedging, and possibly also asset management and share trading had grown too large and should be cut down to size through specific taxes.
"If you want to stop excessive pay in a swollen financial sector you have to reduce the size of that sector or apply special taxes to its pre-remuneration profit," he said.
Turner dismissed fears that a crackdown on financial activity and pay would hit London's competiveness as a financial centre. "There will remain four or five global financial centres, and it is almost certain that one will be London," he said.
However, he added that definitive action needs to be taken: "Higher capital requirements against trading activities will be our most powerful tool to eliminate excessive activity and profits. And if increased capital requirements are insufficient I am happy to consider taxes on financial transactions - Tobin taxes."
These are small taxes levied on foreign exchange transactions proposed by the economist James Tobin back in the 1970s to discourage speculative trading.
The FSA also supports deferred bonuses to be paid in shares rather than cash.
However, Turner stressed he was not setting out any new policy, with tax issues a matter for the chancellor to decide.
The British Bankers' Association warns that the wrong type of regulation or taxes could injure the UK's standing abroad.
It says: "That would mean the UK would receive less revenue through taxes and there would be job losses, not just in the banking industry, but also in all those other businesses, large and small, that provide services to banks.
"On so many occasions in the past the country has lost chunks of industry through making the wrong decisions. Let's not do that again."
David Buik, economist at BGC Partners, took a more critical line: "Lord Turner's proposals in the City will be held in wholesale derision. Taxing banks on transactions is madness and artificially downsizing the financial sector without proper reasons - such as being more circumspect in lending to the consumer - sends an appalling message to the 2.5 million people who stand in the dole queue with little prospects of employment."
He adds: "If the economy is going to recover quickly it needs a vibrant banking sector, restored to full health run by fresh competent management and a much higher quality of non executive director who will refrain from driving shareholder value to the exclusion of prudent banking."