How to avoid a future of 'we are all doomed' financial collapses

In a previous post I laid out the proposition that we are all already doomed to a financial collapse.  So let's say the pessimists are wrong and we're not all doomed, yet.  So how do we best avoid future financial collapses?

The problem at its core is that from time to time there are runs on critical 'too big to fail' financial institutions.  These runs happen because the market suddenly resets its opinion of the safety and soundness of an institution and holders of short term 'demand' liabilities all demand their money back at the same time.  And if one institution goes down, it frightens investors at other institutions and like dominoes they all fall.  This is why governments have instituted failsafe systems, like deposit insurance or central bank lending of last resort - to bolster banks made wobbly by adversity and stop the panic that leads to runs.  But the problem as we found out so painfully in 2008, is that the prospect of a bailout leads bankers to take more risk and investors less care than they would absent the government's security blanket. And that transfers risk from bankers to taxpayers which allows bankers to make unjustifiably large returns.  And because they're still borrowing short and lending long, all we end up with is richer and richer bankers taking more and more risks leading to bigger and bigger panics. As U Chicago economist John Cochrane observes:

"In the end, if you have a big firehouse, then people start to store gas in the basement and don't keep their fire extinguishers ready. This moral hazard is well known, but it is perhaps not so well appreciated just how much more fragile markets are as a result of a century of crisis management."

In a new paper, Professor Cochrane persuasively argues that if the central problem is the uncontrolled run. And the run is caused by the heavy reliance on short term demand liabilities like deposit accounts that are backed by unmatched long maturity assets. Then why don't we simply get rid of short term demand liabilities unless they are fully covered by liquid risk free assets like government securities? The imbalance between short and redeemable on demand and long and locked in is what makes a run possible.  An institution that was funded by short term demand accounts but held liquid, risk free government securities as assets could not be run on.

Cochrane suggests that if this were done the primary driver of systemic financial system collapse:  the bank run, would cease to be a threat and the great majority of financial regulation that has been built to prevent bank runs and then to prevent banks from taking too much risk because they are protected would no longer be necessary.  Core financial institutions that were funded by much more equity or very long term debt for which payment couldn't be demanded would not be at risk.  He suggests both limits on non-government non-risk free short term liabilities as well as taxes on the same.

One of the salient reasons we can do away with the high risk 'fractional reserve' banking model is advances in technology, including instant trading and position transparency that enable us to pay for our latte by directly debuting our money market account.  The Cochrane proposal is somewhat similar to a proposal that Lowell Bryan, McKinsey's banking head made back around 1990:  make 'cash on demand' institutions fully invest in risk free government securities.

Cochrane makes a compelling case and also provides a nice overview of the current bank regulation and governance environment.  It's rather long but if you're interested in the space it is well worth your while.  Here.