Panic-proofing, not preventing bubbles, should be focus of U. S. financial policy

Instead, "a much simpler and more surgical approach is needed," said Morgan Ricks of Vanderbilt Law School, author of The Money Problem: Rethinking Financial Regulation (The University of Chicago Press).

What Ricks proposes cutting out is the pervasive practice of Wall Street institutions funding their operations through very short-term debt markets, where debt matures as often as daily.

This practice, sometimes called shadow banking, results in funds being continuously rolled over. That's when "the problem of runs and panic emerges," Ricks said. "That's really what we ought to be trying to prevent."

The economy could have weathered the 2008 burst of the housing bubble if it were not built on a rickety surface of short-term obligations, Ricks maintains.

Instead of focusing on preventing another bubble or mitigating "systemic risk," Ricks said, financial policy should concentrate on ensuring a system that is stable and panic-proof.

In order to do this, entities that lack a banking charter should be prohibited from using large quantities of short-term or demandable debt, continuously rolled over, to fund portfolios of financial assets, he said.

When they are allowed to operate as they do now, the liabilities they incur are more or less equivalent to bank deposits. However, banks, unlike securities firms, must be chartered and abide by numerous regulatory restraints in exchange for the privilege of using their deposits as money substitutes. Securities firms do the same thing with short-term borrowings without the same regulation or oversight, Ricks said.

"What we're essentially allowing the financial sector to do is create money substitutes without requiring them to have any kind of license or abide by any regulatory constraints to do so," Ricks said.

Ricks, associate professor of law, started developing his proposal while still working as a financial restructuring expert at the U.S. Treasury Department. In exchange for the loss of financing via short-term debt, Ricks' plan calls for securities firms' being freed from many of their regulatory constraints.

"The financial regulatory regime we have now is mind-bogglingly complex," he said. "I teach the staff, and I can't keep up with it."

If Ricks' plan were implemented, Wall Street would have to adjust and use longer-term debt -- that matures in a year or longer instead of a day -- to finance their activities.

Although the change could make Wall Street's operation more expensive, Ricks' thinks his approach should be appealing to both conservatives and liberals. "I think there's something here to like irrespective of your political persuasion. I think … the left would appreciate that it is a structural reform, not a tweak of existing systems that have clearly not worked well."

On the right, he said, the reform would be "much more deliberate and surgical and cast a much narrower net as opposed to a wider net in how we deal with regulating the financial system for stability purposes, and I think that should appeal to people who want less regulation."