People often ask if regulators and legislators have fixedthe flaws in the financial system that took the world to the brink of a second Great Depression. The shortanswer is no.

Yes, the chances of an immediaterepeat of the acute financial meltdown of 2008 are much reduced by the factthat most investors, regulators, consumers, and even politicians will remembertheir financial near-death experience forquite some time. As a result, it could take a while for recklessness to hit full throttleagain.

But, otherwise,little has fundamentally changed. Legislation and regulation produced in thewake of the crisis have mostly served as a patch to preserve the status quo.Politicians and regulators have neither thepolitical courage nor the intellectual conviction needed to return to a much clearer andmore straightforward system.

In his recent speechto the annual, elite central-banking conference in Jackson Hole, Wyoming,the Bank of England’s Andy Haldane made a forceful plea for a return tosimplicity in banking regulation. Haldane rightly complained that bankingregulation has evolved from a small number of very specific guidelines to mind-numbingly complicated statistical algorithms for measuring risk and capital adequacy.

Legislativecomplexity is growing exponentially in parallel.In the United States,the Glass-SteagallAct of 1933 was just 37 pages and helped to produce financial stability forthe greater part of seven decades. The recent Dodd-Frank WallStreet Reform and Consumer Protection Act is 848 pages, and requiresregulatory agencies to produce several hundred additional documents giving evenmore detailed rules. Combined, the legislation appears on track to run 30,000pages.

As Haldane notes,even the celebrated “Volcker rule,” intendedto build a better wall between more mundanecommercial banking and riskier proprietarybank trading, has been hugely watered downas it grinds throughthe legislative process. The former Federal Reserve chairman’s simpleidea has been co-opted and diluted through hundreds of pages of legalese.

The problem, atleast, is simple: As finance has become more complicated, regulators have triedto keep up by adopting ever more complicated rules. It is an arms race that underfunded government agencies have no chance towin.

Even back in the 1990’s, regulators would privately complainof the difficulty of retaining any staff capable of understanding the rapidlyevolving derivatives market. Research assistants with one year of experienceworking on derivatives issues would get bid awayby the private sector at salaries five times whatthe government could pay.

Aroundthe same time, in the mid-1990’s,academics began to publish papers suggesting that the only effective way toregulate modern banks was a form of self-regulation. Let banks design their ownrisk management systems, audit them to the limited extent possible, and thenseverely punish them if they produce a loss outsideagreed parameters.

Many economistsargued that these clever models were flawed,because the punishment threat was not credible,particularly in the case of a systemic meltdown affecting a large part of thefinancial system. But the papers were published anyway, and the ideas wereimplemented. It is not necessary to recount the consequences.

The clearest and mosteffective way to simplify regulation has been advanced in a series of importantpapers by Anat Admati of Stanford (with co-authors including Peter DeMarzo,Martin Hellwig, and Paul Pfleiderer). Their basicpoint is that financial firms should be forced to fund themselves in a morebalanced fashion, and not to rely so heavily on debt finance.

Admati and hercolleagues recommend requirements that force financial firms to generate equityfunding either through retained earnings or, in the case of publicly tradedfirms, through stock issuance. The statusquo allows banks instead to leverage taxpayer assistance by holding razor-thin equity margins, relying on debt to afar greater extent than typical large non-financial firms do. Some large firms,such as Apple, hold virtually no debt at all. Greater reliance on equity wouldgive banks a much larger cushion to absorb losses.

The financialindustry complains that efforts to force greater equity funding would curtail lending, but this is just nonsense in ageneral equilibrium setting. Nevertheless,governments have been very timid inadvancing on this front, with the new Basel III rules taking only a baby step toward real change.

Of course, it is noteasy to legislate financial reform in a stagnant global economy, for fear of impeding credit and turning a sluggish recoveryinto a full-blown recession. And, surely, academics are also to blame for the inertia, with many of them still defending elegant but deeply flawed models of perfectmarkets that create an illusion of safety for a system that is in fact highlyrisk-prone.

The fashionable ideaof allowing banks to issue “contingentcapital” (debt that becomes equity in a systemic crisis) is no more crediblethan the idea of committing to punish banks severely in the event of a crisis.A simpler and more transparent system would ultimately lead to more lending andgreater stability, not less. It is high time to restore sanity to financial-market regulation.