"We know that the exaggerated de-regulation (of the financial markets in the past) was a mistake," Finance Minister Wolfgang Schäuble told a news conference when presenting the draft law.
"We allowed ourselves to be dazzled by technical innovation, new financial products and breathless developments on the financial markets," he said.
But in the wake of the financial crises, Germany had come to the realisation that "no financial market, no financial player and no financial product must be allowed to escape supervision," Schäuble said.
"If you want the chance to make a profit, you must also shoulder the risk," and the taxpayer should not be expected to foot the bill, the minister said.
"We're establishing step by step a new regulatory framework for the financial markets," he said.
Under the new legislation, which Schäuble said he hopes to have passed by parliament by June, large banks will have to separate their different areas of activity in order to protect customers' deposits from riskier areas of operations.
The rule will apply to institutions where high-risk operations such as high-frequency trading or hedge-fund financing make up either 20 percent of the balance sheet value or surpass €100 billion ($135 billion) in value.
The banks concerned will be required to transfer their risky businesses into legally and financially separate units.
Schäuble estimated that between 10 and 12 banks in Germany fulfil these criteria and would therefore be affected.
He declined to name any, but the rules will certainly affect the country's two biggest banks, Deutsche Bank and Commerzbank, as well as regional banking giant Landesbank Baden-Württemberg (LBBW).
The law also requires banks to draw up so-called "wills" or emergency plans for restructuring or winding down once they get into financial difficulty.
High-level managers and executives will face up to five years in jail if they are found guilty of neglecting their risk management duties and allowing their company to run into trouble.
The legislation would directly tackle the shortcomings that make the financial system vulnerable to crisis and also tackle the "lack of responsibility on the part of banks and bankers," Schäuble said.
Banking separation is an idea promoted by the head of the Finnish central bank and European Central Bank governing council member Erkki Liikanen as a measure for reducing risk in the banking sector.
France has also drawn up similar legislation and Britain, too, is mulling an overhaul along similar lines.
But a Europe-wide process would likely take years, so Germany was seeking to provide added impetus by pressing ahead with its own national legislation now, Schäuble argued.
Nevertheless, the banks themselves are fiercely opposed to the changes.
Deutsche Bank has repeatedly slammed the idea as harmful both to the German economy and German companies.
It argues that if it can no longer use deposits to support its activities in investment banking, refinancing costs would automatically rise and that would narrow the financing possibilities of major companies.
The BdB German banking federation agreed.
"The draft legislation will undermine Germany as a financial centre," complained BdB president Andreas Schmitz.
"The measures approved by the cabinet today are folly," he said, slamming them as cheap populist moves by politicians with an eye on the general election this September.
"There is no evidence that separating off trading activities will lead to greater stability on the financial markets," Schmitz argued.
Instead of rushing ahead with its own unilateral national regulatory measures, Germany should wait for new rules to be established at a European level, he said.