Arguments for lower interest rates

Lower interest rates stimulate the economy by making borrowing less expensive. The Fed lowered the target for the Federal funds rate from 5.25% to a target range of 0-0.25% since 18 September 2007.^[12][13][14] Central banks around the world have also lowered interest rates.

Lower interest rates may also help banks "earn their way out" of financial difficulties, because banks can borrow at very low interest rates from depositors and lend at higher rates for mortgages or credit cards. In other words, the "spread" between bank borrowing costs and revenues from lending increases. For example, a large U.S. bank reported in February 2009 that its average cost to borrow from depositors was 0.91%, with a net interest margin (spread) of 4.83%.^[15] Profits help banks build back equity or capital lost during the crisis.

Arguments against lower interest rates

Other things being equal, economic theory suggests that lowering interest rates relative to other countries weakens the domestic currency. This is because capital flows to nations with higher interest rates (after subtracting inflation and the political risk premium), causing the domestic currency to be sold in favor of foreign currencies, a variation of which is called the carry trade. Further, there is risk that the stimulus provided by lower interest rates can lead to demand-driven inflation once the economy is growing again. Maintaining interest rates at a low level also discourages saving, while encouraging spending.

Arguments for credit easing

According to Ben Bernanke, expansion of the Fed balance sheet means the Fed is electronically creating money, necessary "... because our economy is very weak and inflation is very low. When the economy begins to recover, that will be the time that we need to unwind those programs, raise interest rates, reduce the money supply, and make sure that we have a recovery that does not involve inflation."^[19]

Arguments against credit easing

Credit easing involves increasing the money supply, which presents inflationary risks that could weaken the dollar and make it less desirable as a reserve currency, affecting the ability of the U.S. government to finance budget deficits. The Fed is lending against increasingly risky collateral and in great amounts. The challenge to reduce the money supply at the right cadence and amount will be unprecedented once the economy is on firmer footing. Further, reducing the money supply as the economy begins to recover may place downward pressure against economic growth. In other words, raising the money supply to cushion a downturn will have a dampening effect on the subsequent upturn. There is also risk of inflation and devaluation of the currency.^[19] Critics have argued that worthy borrowers can still get credit and that credit easing (and government intervention more generally) is really an attempt to maintain a debt-driven standard of living that was unsustainable.

Arguments for nationalization or recapitalization

Permanent nationalization of certain financial functions may be an effective way to maintain financial system stability and prevent future crisis.^[22] There is strong evidence that within the U.S., competition between mortgage securitizers contributed to declining underwriting standards and increased risk that led to the late 2000s financial crisis.^[22] The largest, most powerful entities – with the strongest ties to the government and the heaviest regulatory burdens – generally originated the safest, best performing mortgages.^[22] Furthermore, the period of greatest competition coincided with the period during which the worst loans were originated.^[22] In addition, countries with less competitive financial sectors and greater government involvement in finance proved to be far more stable and resilient than the United States in the late 2000s (decade).^[22]

Another advantage of nationalization is that it eliminates the moral hazard inherent in private ownership of systemically important financial institutions.^[22] Systemically important financial institutions are likely to receive government bailouts in the event of failure.^[22] Unless these bailouts are structured as a government takeover, and losses are imposed on bondholders and shareholders, investors have incentives to take extreme risks, to capture the upside during boom times, and to impose losses on taxpayers in times of crisis.^[22] Permanent nationalization eliminates this dynamic by concentrating the full upside and downside with taxpayers. Permanent nationalization therefore may lead to lower and more rational risk levels in the financial system.

Permanent nationalization also provides the government with profits, a source of income – other than taxes – which can be used to recoup losses from past bailouts or to build a reserve for future bailouts.^[22] The political power of the owners and top executives and board members of private, systemically important financial institutions may insulate them from taxes, insurance charges, and regulations aimed at curbing risk. Nationalization could be an effective way to curb this political power and open the door to reform.

Another advantage of nationalization is that it gives the government greater knowledge, understanding, and capabilities within the financial markets, and may enhance the government's ability to act effectively during times of crisis.^[22]

Economist Paul Krugman has argued for bank nationalization: "A better approach would be to do what the government did with zombie savings and loans at the end of the 1980s: it seized the defunct banks, cleaning out the shareholders. Then it transferred their bad assets to a special institution, the Resolution Trust Corporation; paid off enough of the banks’ debts to make them solvent; and sold the fixed-up banks to new owners." He advocates an "explicit, though temporary government takeover" of insolvent banks.^[23]

Economist Nouriel Roubini said: "I'm worried that many banks [are] zombies, they should be shut down, the sooner the better ... otherwise they will take deposits and make other risky loans."^[24] He also wrote: "Nationalization is the only option that would permit us to solve the problem of toxic assets in an orderly fashion and finally allow lending to resume." He recommended four steps:

1. Determine which banks are insolvent.
2. Immediately nationalize insolvent institutions or place them into receivership. The equity holders will be wiped out, and long-term debt holders will have claims only after the depositors and other short-term creditors are paid off.
3. Separate nationalized bank assets into good and bad pools. Banks carrying only the good assets would then be privatized.
4. Bad assets would be merged into one enterprise. The assets could be held to maturity or eventually sold off with the gains and risks accruing to the taxpayers.^[25]

Harvard professor Niall Ferguson argued: "Worst of all [indebted] are the banks. The best evidence that we are in denial about this is the widespread belief that the crisis can be overcome by creating yet more debt ... banks that are de facto insolvent need to be restructured – a word that is preferable to the old-fashioned “nationalisation”. Existing shareholders will have to face that they have lost their money. Too bad; they should have kept a more vigilant eye on the people running their banks. Government will take control in return for a substantial recapitalisation after losses have meaningfully been written down."^[26]

Common Equity to Total Assets Ratios for Major USA Banks

Banks that are insolvent from a balance sheet perspective (i.e., liabilities exceed assets, meaning equity is negative) may restrict their lending. Further, they are at increased risk of making risky financial bets due to moral hazard (i.e., either they make money if the bets work out or will be bailed out by the government, a dangerous position from society's point of view). An unstable banking system also undermines economic confidence.

These factors (among others) are why insolvent financial institutions have historically been taken over by regulators. Further, loans to a struggling bank increase assets and liabilities, not equity. Capital is therefore "tied up" on the insolvent bank's balance sheet and cannot be used as productively as it could be at a healthier financial institution. Banks have taken significant steps to obtain additional capital from private sources. Further, the U.S. and other countries have injected capital (willingly or unwillingly) into larger financial institutions. Alan Greenspan estimated in March 2009 that U.S. banks will require another $850 billion of capital, representing a 3-4 percentage point increase in equity capital to asset ratios.^[27]

Following a model initiated by the United Kingdom bank rescue package,^[28][29] the U.S. government authorized the injection of up to $350 billion in equity in the form of preferred stock or asset purchases as part of the $700 billion Emergency Economic Stabilization Act of 2008, also called the Troubled Asset Relief Program (TARP).

Steven Pearlstein has advocated government guarantees for new preferred stock, to encourage investors to provide private capital to the banks.^[30]

For a summary of U.S. government financial commitments and investments related to the crisis, see CNN – Bailout Scorecard.

For a summary of TARP funds provided to U.S. banks as of December 2008, see Reuters-TARP Funds.

Arguments against nationalization or recapitalization

Nationalization wipes out current shareholders and may impact bondholders. It involves risk to taxpayers, who may or may not recoup their investment. The government may not be able to manage the institution better than the current management. The threat of nationalization may make it challenging for banks to obtain funding from private sources.^[31]

Government intervention may not always be fair or transparent. Who gets a bailout and how much? A Congressional Oversight Panel (COP) chaired by Harvard Professor Elizabeth Warren was created to monitor the implementation of the TARP program. COP issued its first report on 10 December 2008. In related interviews, Professor Warren indicated it was difficult to obtain clear answers to her panel's questions.^[32][33]

Arguments for toxic asset purchases

Removing complex and difficult to value assets from banks' balance sheets across the system in exchange for cash is a major win for the banks, provided they can command an appropriate price for the assets. Further, transparency of financial institution health is improved across the system, improving confidence, as investors can be more assured of the valuation of these firms. Financially healthy firms are more likely to lend.

U.S. Treasury Secretary Timothy Geithner announced a plan during March 2009 to purchase "legacy" or "toxic" assets from banks. The Public-Private Partnership Investment Program involves government loans and guarantees to encourage private investors to provide funds to purchase toxic assets from banks. The press release states: "This approach is superior to the alternatives of either hoping for banks to gradually work these assets off their books or of the government purchasing the assets directly. Simply hoping for banks to work legacy assets off over time risks prolonging a financial crisis, as in the case of the Japanese experience. But if the government acts alone in directly purchasing legacy assets, taxpayers will take on all the risk of such purchases – along with the additional risk that taxpayers will overpay if government employees are setting the price for those assets."^[34]

Arguments against toxic asset purchases

A key question is what to pay for the assets. For example, a bank may believe an asset, such as a mortgage-backed security with a claim on cash from the underlying mortgages, is worth 50 cents on the dollar, while it may only be able to find a buyer on the open market for 30 cents. The bank has no incentive to sell the assets at the 30 cent price. But if taxpayers pay 50 cents, they are paying more than market value, an unpopular choice for taxpayers and politicians in a bailout. To truly be helping the banks, the taxpayers would have to pay more than the value at which the bank is carrying the asset on its books, or more than the 50 cent price. Further, who will determine the price and how will ownership of the assets be administered? Does the government entity set up to make these purchases have the expertise?

Economist Joseph Stiglitz criticized the plan proposed by U.S. Treasury Secretary Timothy Geithner to purchase toxic assets: "Paying fair market values for the assets will not work. Only by overpaying for the assets will the banks be adequately recapitalized. But overpaying for the assets simply shifts the losses to the government. In other words, the Geithner plan works only if and when the taxpayer loses big time." He stated that toxic asset purchases represents "ersatz capitalism," meaning gains are privatized while losses are socialized.^[35]

The government's initial Troubled Asset Relief Program (TARP) proposal was derailed because of these questions and because of the timeline involved in successfully valuing, purchasing, and administering such a program was too long with an imminent crisis faced in September–October 2008.

Martin Wolf has argued that the purchase of toxic assets may distract the U.S. Congress from the urgent need to recapitalize banks and may make it more politically difficult to take necessary action.^[36]

Research by JP Morgan and Wachovia indicates that the value of toxic assets (technically CDO's of ABS) issued during late 2005 to mid-2007 are worth between 5 cents and 32 cents on the dollar. Approximately $305 billion of the $450 billion of such assets created during the period are in default. By another indicator (the ABX), toxic assets are worth about 40 cents on the dollar, depending on the precise vintage (period of origin).^[37]

Arguments for bondholder and counterparty haircuts

If the key issue is bank solvency, converting debt to equity via bondholder haircuts presents an elegant solution to the problem. Not only is debt reduced along with interest payments, but equity is simultaneously increased. Investors can then have more confidence that the bank (and financial system more broadly) is solvent, helping unfreeze credit markets. Taxpayers do not have to contribute money and the government may be able to just provide guarantees in the short-term to further support confidence in the recapitalized institution.

Economist Joseph Stiglitz testified that bank bailouts "... are really bailouts not of the enterprises but of the shareholders and especially bondholders. There is no reason that American taxpayers should be doing this." He wrote that reducing bank debt levels by converting debt into equity will increase confidence in the financial system. He believes that addressing bank solvency in this way would help address credit market liquidity issues.^[41]

Fed Chairman Ben Bernanke argued in March 2009: "If a federal agency had had such tools on September 16 [2008], they could have been used to put AIG into conservatorship or receivership, unwind it slowly, protect policyholders, and impose haircuts on creditors and counterparties as appropriate. That outcome would have been far preferable to the situation we find ourselves in now."^[42]

Harvard professor Niall Ferguson has argued for bondholder haircuts at insolvent banks: "Bondholders may have to accept either a debt-for-equity swap or a 20 per cent “haircut” (a reduction in the value of their bonds) – a disappointment, no doubt, but nothing compared with the losses when Lehman went under."^[43]

Economist Jeffrey Sachs has also argued for bondholder haircuts: "The cheaper and more equitable way would be to make shareholders and bank bondholders take the hit rather than the taxpayer. The Fed and other bank regulators would insist that bad loans be written down on the books. Bondholders would take haircuts, but these losses are already priced into deeply discounted bond prices."^[44]

Dr. John Hussman has argued for significant bondholder haircuts: "Stabilize insolvent financial institutions through receivership if the bondholders of the institution are unwilling to swap debt for equity. In virtually all cases, the liabilities of these companies to their own bondholders are capable of fully absorbing all losses without the need for public funds to defend those bondholders ... The sum total of the policy responses to this crisis has been to defend the bondholders of distressed financial institutions at public expense."^[45]

Professor and author Nassim Nicholas Taleb argued during July 2009 that deleveraging through forcible conversion of debt to equity swaps for both banks and homeowners is "the only solution." He advocates much more aggressive and system-wide action. He emphasized the complexity and fragility of the current system due to excessive debt levels and stated that the system is in the process of crashing. He believes any "green shoots" (i.e., signs of recovery) should not distract from this response.^[46]

Arguments against bondholder and counterparty haircuts

Investors may balk at providing funding to U.S. institutions if bonds become subject to arbitrary haircuts due to nationalization.^[47] Insurance companies and other investors that own many of the bonds issued by major financial institutions may suffer large losses if they must accept debt for equity swaps or other forms of haircuts.^[48]

The fear of losing one's investments which is contributing to the recession would increase with each expropriation.

Arguments for a systemic risk regulator

Fed Chairman Ben Bernanke stated there is a need for "well-defined procedures and authorities for dealing with the potential failure of a systemically important non-bank financial institution."^[97] He also argued in March 2009: "... I would note that AIG offers two clear lessons for the upcoming discussion in the Congress and elsewhere on regulatory reform. First, AIG highlights the urgent need for new resolution procedures for systemically important nonbank financial firms. If a federal agency had had such tools on September 16, they could have been used to put AIG into conservatorship or receivership, unwind it slowly, protect policyholders, and impose haircuts on creditors and counterparties as appropriate. That outcome would have been far preferable to the situation we find ourselves in now. Second, the AIG situation highlights the need for strong, effective consolidated supervision of all systemically important financial firms. AIG built up its concentrated exposure to the subprime mortgage market largely out of the sight of its functional regulators. More-effective supervision might have identified and blocked the extraordinarily reckless risk-taking at AIG-FP. These two changes could measurably reduce the likelihood of future episodes of systemic risk like the one we faced at AIG."^[42]

Economists Nouriel Roubini and Lasse Pederson recommended in January 2009 that capital requirements for financial institutions be proportional to the systemic risk they pose, based on an assessment by regulators. Further, each financial institution would pay an insurance premium to the government based on its systemic risk.^[98]

British Prime Minister Gordon Brown and Nobel laureate Michael Spence have argued for an "early warning system" to help detect a confluence of events leading to systemic risk.^[99]

Former Federal Reserve Chairman Paul Volcker testified in September 2009 regarding how to deal with a systemically important non-bank that might get into trouble:

1. A government entity should have the authority to take over a failed or failing non-bank institution and manage that institution.
2. The regulator should attempt to find a merger partner. If no partner can be found, the entity should ask debtholders to exchange debt for equity to make the company solvent again.
3. If none of the above works, the regulator should arrange an orderly liquidation.

Volcker argued that none of the above involves injection of government or taxpayer money but involves an organized procedure for winding down a systemically important non-banking institutions. He advocated that this authority should reside with the Federal Reserve rather than a council of regulators.^[100][101]

Arguments against a systemic risk regulator

Libertarians and conservatives argue for minimal or no regulation, preferring to let markets regulate themselves. Writers such as Peter Wallison, a former Wall Street lawyer, Republican political figure, and longtime advocate of financial deregulation and privatization, argue that it was government intervention, such as allegedly requiring Fannie Mae and Freddie Mac to lower lending standards,^[102] that caused the crisis in the first place and that extensive regulation of banks was ineffective.^[103]

Independent academic scholars have disputed these assertions, noting that Fannie Mae and Freddie Mac loans performed better than those securitized by more lightly regulated investment banks, and that government mandated CRA loans performed better than market driven subprime mortgages.^[22] They've also questioned Wallison's impartiality, noting extensive funding for AEI by the financial industry, and AEI's apparent efforts to increase financial industry donations by suggesting that Wallison would use his position on the Financial Crisis Inquiry Commission to benefit the Financial Industry.^[22] Critics have also raised questions about Wallison's methodology and use of data.^[22]

Arguments for regulating the shadow banking system

Leverage ratios of investment banks increased significantly between 2003 and 2007.

Nobel laureate Paul Krugman described the run on the shadow banking system as the "core of what happened" to cause the crisis. "As the shadow banking system expanded to rival or even surpass conventional banking in importance, politicians and government officials should have realized that they were re-creating the kind of financial vulnerability that made the Great Depression possible – and they should have responded by extending regulations and the financial safety net to cover these new institutions. Influential figures should have proclaimed a simple rule: anything that does what a bank does, anything that has to be rescued in crises the way banks are, should be regulated like a bank." He referred to this lack of controls as "malign neglect."^[104]

Krugman wrote in April 2010: "What we need now are two things: (a) regulators need the authority to seize failing shadow banks, the way the Federal Deposit Insurance Corporation already has the authority to seize failing conventional banks, and (b) there have to be prudential limits on shadow banks, above all limits on their leverage."^[105]

The crisis surrounding the failure of Long-Term Capital Management in 1998 was an example of an unregulated shadow banking institution that many believed posed a systemic risk.

Economist Nouriel Roubini argued that market discipline, or free market incentives for depositors and investors to monitor banks to prevent excessive risk taking, breaks down when there is mania or bubble psychology inflating asset prices. People take excessive risks and ignore risk managers during these periods. Without proper regulation, the "law of the jungle" rules. Excessive financial innovation that is not controlled is "very risky." He stated: "Self-regulation is meaningless; it means no regulation."^[106]

Former Chairman and CEO of Citigroup Chuck Prince said in July 2007: "When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing."^[107] Market pressures to grow profits by taking increasing risks were significant throughout the boom period. The largest five investment banks (such as Bear Stearns and Lehman Brothers), were either taken over, liquidated, or converted to depository banks. These institutions had increased their leverage ratios, a measure of risk defined as the ratio of assets or debt to capital, significantly from 2003 to 2007 (see diagram).

Arguments against regulating the shadow banking system

Writers at the financial-industry-funded American Enterprise Institute and similar corporate-funded think tanks have claimed that banking regulations did not prevent the crisis, and that regulations therefore can never be effective.^[22] According to Peter J. Wallison of the American Enterprise Institute, "... the federal government had to commit several hundred billion dollars for a guarantee of Citigroup's assets, despite the fact that examiners from the Office of the Comptroller of the Currency (OCC) have been inside the bank full-time for years, supervising the operations of this giant institution under the broad powers granted by FDICIA to bank supervisors." He questions whether regulation is better than market discipline at preventing the failure of financial institutions, as follows:^[103]

• "The very existence of regulation – especially safety-and-soundness regulation – creates moral hazard and reduces market discipline. Market participants believe that if the government is looking over the shoulder of the regulated industry, it is able to control risk-taking, and lenders are thus less wary that regulated entities are assuming unusual or excessive risks.
• Regulation creates anticompetitive economies of scale. The costs of regulation are more easily borne by large companies than by small ones. Moreover, large companies have the ability to influence regulators to adopt regulations that favor their operations over those of smaller competitors, particularly when regulations add costs that smaller companies cannot bear.
• Regulation impairs innovation. Regulatory approvals necessary for new products or services delay implementation, give competitors an opportunity to imitate, and add costs to the process of developing new ways of doing business or new services.
• Regulation adds costs to consumer products. These costs are frequently not worth the additional amount that consumers are required to pay.
• Safety-and-soundness regulation in particular preserves weak managements and outdated business models, imposing long-term costs on society."

These industry funded think tanks have claimed that market bubbles are not caused by failure of a free market to control manias, but rather by government policy.

Others have disputed these claims.^[22]

Arguments for stronger bank capital requirements / leverage restriction

Nobel prize winner Joseph Stiglitz has recommended that the USA adopt regulations restricting leverage, and preventing companies from becoming "too big to fail."^[108]

Alan Greenspan has called for banks to have a 14% capital ratio, rather than the historical 8-10%. Major U.S. banks had capital ratios of around 12% in December 2008 after the initial round of bailout funds. The minimum capital ratio is regulated.^[109]

Greenspan also wrote in March 2009: "New regulatory challenges arise because of the recently proven fact that some financial institutions have become too big to fail as their failure would raise systemic concerns. This status gives them a highly market-distorting special competitive advantage in pricing their debt and equities. The solution is to have graduated regulatory capital requirements to discourage them from becoming too big and to offset their competitive advantage." He estimated that another $850 billion will be required to properly capitalize major banks.^[110]

Economist Raghuram Rajan has argued for regulations requiring "contingent capital." For example, financial institutions would be required to pay insurance premiums to the government during boom periods, in exchange for payments during a downturn. Alternatively, they would issue debt that converts to equity during downturns or when certain capital thresholds are met, both reducing their interest burden and expanding their capital base to enable lending.^[111]

Economist Paul McCulley advocated "counter-cyclical regulatory policy to help modulate human nature." He cited the work of economist Hyman Minsky, who believed that human behavior is pro-cyclical, meaning it amplifies the extent of booms and busts. In other words, humans are momentum investors rather than value investors. Counter-cyclical policies would include increasing capital requirements during boom periods and reducing them during busts.^[112]

JP Morgan Chase CEO Jamie Dimon also supported increased capital requirements: "Also welcome in the administration's new proposals is the focus on strong capital and liquidity requirements – not just for traditional banks but for a broad range of financial institutions. We now know that "once-in-a-generation" swings in the business cycle are anything but. All financial institutions, wherever they're regulated, must stand ready with strong capital reserves to serve as a cushion during times of unexpected market and economic difficulties. This must be combined with adequate loan loss reserves, to cover the expected losses from the growing number of borrowers who likely will default, and necessary liquidity, in case credit markets freeze up as they did last fall."^[113]

Arguments against bank capital requirements / leverage restriction

Higher capital ratios or requirements mean banks cannot lend as much of their capital base, which increases interest rates and theoretically places downward pressure on economic growth relative to freer lending regulations.

During a boom (before the corresponding bust begins), even most economists are unable to distinguish the boom from a period of normal (but rapid) growth. Thus officials will be unwilling or politically unable to impose counter-cyclical policies during a boom. No one wants to take away the punch bowl just when the party is warming up.

Arguments for breaking-up large financial institutions

Economists Joseph Stiglitz and Simon Johnson have argued that institutions that are "too big to fail" should be broken up, perhaps by splitting them into smaller regional institutions. Dr. Stiglitz argued that big banks are more prone to taking excessive risks due to the availability of support by the federal government should their bets go bad.^[114]

Various Wall Street special interests would likely be weakened if major financial institutions are broken-up or no longer allowed to make campaign contributions. Further, restrictions could be placed more easily on the "revolving door" of executives between investment banks and various government agencies or departments.^[115] Similar rules regarding conflicts of interest were placed on accounting firms and the corporations they audit as part of the Sarbanes–Oxley Act of 2002.

The Glass–Steagall Act was enacted after the Great Depression. It separated commercial banks and investment banks, in part to avoid potential conflicts of interest between the lending activities of the former and rating activities of the latter. Economist Joseph Stiglitz criticized the repeal of key provisions of the Act. He called its repeal the "culmination of a $300 million lobbying effort by the banking and financial services industries ... spearheaded in Congress by Senator Phil Gramm." He believes it contributed to this crisis because the risk-taking culture of investment banking dominated the more conservative commercial banking culture, leading to increased levels of risk-taking and leverage during the boom period.^[116]

Martin Wolf wrote in June 2009: "A business that is too big to fail cannot be run in the interests of shareholders, since it is no longer part of the market. Either it must be possible to close it down or it has to be run in a different way. It is as simple – and brutal – as that."^[117]

Niall Ferguson wrote in September 2009: "What's needed is a serious application of antitrust law to the financial-services sector and a speedy end to institutions that are 'too big to fail.' In particular, the government needs to clarify that federal insurance applies only to bank deposits and that bank bondholders will no longer protected, as they have been in this crisis. In other words, when a bank goes bankrupt, the creditors should take the hit, not the taxpayers."^[118]

The New York Times editorial board wrote in December 2009: "If we have learned anything over the last couple of years, it is that banks that are too big to fail pose too much of a risk to the economy. Any serious effort to reform the financial system must ensure that no such banks exist."^[119]

President Barack Obama argued in January 2010 that depository banks should not be able to trade on their own accounts, which effectively brings back Glass-Steagall Act rules separating depository and investment banking. This is because taxpayers guarantee the deposits of depository banks and high-risk bets with that money would be inappropriate.^[120]

Arguments against breaking-up large financial institutions

There is evidence that certain financial functions may be more stable within an oligopolistic or monopolistic market structure, and that competition may contribute to declining standards and instability.^[22]

Some corporate customers may be inconvenienced by having to work with separate depository and investment banks, through the re-enactment of a law such as the Glass-Steagal Act.

Arguments for restricting short-selling

Some believe that bear raids or deliberate attempts to reduce the value of stocks caused the downfall of certain firms, such as Bear Stearns. Hedge funds or large investors with significant short positions allegedly began a rumor campaign, creating a crisis of confidence regarding the firm. Since it was financed by short-term loans that frequently required replenishment and was highly leveraged (i.e., vulnerable), such rumors may have contributed to bankrupting the firm as lenders refused to extend financing and investors pulled funds from the company.^[121][122]

On 18 September 2008, UK regulators announced a temporary ban on short-selling the stock of financial firms.^[123]

Arguments against restricting short-selling

The ratio of those "long" (i.e., those who are betting the stock will go up) or "short" (i.e., those who are betting the stock will go down) sends important signals regarding the future direction of the stock or expectations of future performance. Short selling is only harmful if it reduces the price of the investment below what its value should be. However, if that occurs, then the short seller would suffer a loss since the price would tend to go back up to its appropriate value; and too many such losses would put him out of business. Thus no regulation is needed. Short selling helps bring prices down to their appropriate level more quickly.

Bear raids (like bank runs) are only a danger to firms which are over-extended and thus deserve to fail.

Arguments for regulating credit derivatives

Warren Buffett famously referred to derivatives as "financial weapons of mass destruction" in early 2003.^[126][127] Former President Bill Clinton and former Federal Reserve Chairman Alan Greenspan indicated they did not properly regulate derivatives, including credit default swaps (CDS).^[128][129] A bill (the Derivatives Markets Transparency and Accountability Act of 2009 (H.R. 977) has been proposed to further regulate the CDS market and establish a clearinghouse. This bill would provide the authority to suspend CDS trading under certain conditions.^[130]

Economist Joseph Stiglitz summarized how CDS contributed to the systemic meltdown: "With this complicated intertwining of bets of great magnitude, no one could be sure of the financial position of anyone else-or even of one's own position. Not surprisingly, the credit markets froze."^[131]

NY Insurance Superintendent Eric Dinallo argued in April 2009 for the regulation of CDS and capital requirements sufficient to support financial commitments made by institutions. "Credit default swaps are the rocket fuel that turned the subprime mortgage fire into a conflagration. They were the major cause of AIG’s – and by extension the banks’ – problems. ... In sum, if you offer a guarantee – no matter whether you call it a banking deposit, an insurance policy, or a bet – regulation should ensure you have the capital to deliver." He also wrote that banks bought CDS to enable them to reduce the amount of capital they were required to hold against investments, thereby avoiding capital regulations.^[132]

Financier George Soros has recommended that credit default swaps no longer be traded, calling them "instruments of destruction that ought to be outlawed."^[133]

U.S. Treasury Secretary Timothy Geithner proposed a framework for legislation to regulate derivatives during May 2009, stating that "... derivatives are largely excluded or exempted from regulation." Key elements of the framework include:^[134]

• Require clearing of all standardized over-the-counter (OTC) derivatives through regulated central counterparties (CCPs);
• Robust margin and capital requirements for key market participants;
• Financial reporting and disclosure requirements;
• Clarify regulatory enforcement authorities of the U.S. Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC); and
• Limiting the types of counterparties that can participate in derivative transactions.

Arguments against regulating credit derivatives

Credit derivatives provide market signals regarding the risk of particular investments. For example, the cost of providing CDS protection for particular bonds is a signal regarding the risk of those bonds. CDS also allow particular credit risks to be hedged, as an entity can purchase protection from many sources of credit risk, much like an insurance policy. While total notional value related to CDS are enormous (estimated between $25–$50 trillion), the true exposure related to that notional value is approximately $2.5-$3.0 trillion. This amount would only be lost if the underlying assets lost their entire value (i.e., akin to all the cars insured by car insurance companies being totaled simultaneously; CDS insure bonds instead of cars), which is outside any reasonable scenario. Since many of these CDS provide protection against defaults of bonds in quality companies, true risk of loss related to CDS is considerably less.^[135]

Arguments for establishing minimum down payments and lending standards

Lending standards declined sharply before the financial crisis. There is strong evidence that lending standards generally loosen during prosperous times, and that permitting financial institutions to compete with each other for revenue and market share by lowering standards lead to a "race toward the bottom."^[22] There is also strong evidence that the expansion in mortgage lending including subprime lending, and more generally lending in lower income census tracts, was disproportionately fueled by lightly regulated non-bank independent mortgage lenders.^[138] There is also evidence that areas served predominantly by independent lenders saw sharper increases in foreclosure rates.^[138]

Warren Buffett stated in February 2009: "The present housing debacle should teach home buyers, lenders, brokers and government some simple lessons that will ensure stability in the future. Home purchases should involve an honest-to-God down payment of at least 10 percent and monthly payments that can be comfortably handled by the borrower's income. That income should be carefully verified."^[139]

China has down payment requirements that exceed 20%, with higher amounts for non-primary residences.^[140]

Economist Stan Leibowitz argued that the most important factor in foreclosures was the extent to which the homeowner has positive equity. Although only 12% of homes had negative equity, they constituted 47% of all foreclosures during the second half of 2008. He advocated "relatively high" minimum down payments and stronger underwriting standards. "If substantial down payments had been required, the housing price bubble would certainly have been smaller, if it occurred at all, and the incidence of negative equity would have been much smaller even as home prices fell. A further beneficial regulation would be a strengthening, or at least clarifying at a national level, of the recourse that mortgage lenders have if a borrower defaults. Many defaults could be mitigated if homeowners with financial resources know they can't just walk away."^[141]

A 2009 Republican congressional staff report cited government pressure as a cause of the crisis: "Washington must reexamine its politically expedient but irresponsible approach to encouraging higher levels of home ownership based on imprudently small down payments and too little emphasis on borrowers’ creditworthiness and ability to repay their loans."^[142]

The Fed implemented new rules for mortgage lenders in July 2008.^[143]

Arguments against establishing minimum down payments and lending standards

Higher lending standards may place downward pressure on economic growth and prevents those of lesser economic means from owning their own home.

Arguments for regulating executive compensation

Economist Joseph Stiglitz argued: "We need first to correct incentives for executives, reducing the scope for conflicts of interest and improving shareholder information about dilution in share value as a result of stock options. We should mitigate the incentives for excessive risk-taking and the short-term focus that has so long prevailed, for instance, by requiring bonuses to be paid on the basis of, say, five-year returns, rather than annual returns."^[144]

The ratio of average CEO total direct compensation relative to that of the average worker increased from 29 times (1969) to 126 times (1992) and 275 times in 2007.^[145]

Bank CEO Jamie Dimon argued: "Rewards have to track real, sustained, risk-adjusted performance. Golden parachutes, special contracts, and unreasonable perks must disappear. There must be a relentless focus on risk management that starts at the top of the organization and permeates down to the entire firm. This should be business-as-usual, but at too many places, it wasn't."^[146]

President Obama has assigned Kenneth Feinberg as "Special Master" on executive pay, for firms that received government assistance, including several major banks and General Motors. He will review the pay packages proposed by these firms for their top executives.^[147]

Arguments against regulating executive compensation

The top executives of a business are primarily responsible for ensuring that the business is conducted in a profitable manner; this can make the difference between a viable business and a failure which must be liquidated. Very few people are willing and able to perform that kind of task. Thus it is reasonable for boards of directors of large corporations to pay very high salaries to top executives who can perform. To ensure performance, it is usual to link the compensation to measures of the business's success, e.g. by paying the executive mostly in stock or call options which are deferred (to give the stock market a chance to evaluate the executive's performance before he can cash in on it). When especially successful, the executive can expect to receive compensation exceeding the average of other executives in comparable positions.

Some say the opposition to such high compensation is largely based on envy – many people do not want to acknowledge that the work of another person could be worth hundreds of times more than their own work. Perhaps they resent the success of others. Critics say that if government regulates executive compensation, then it will be removing the main tool by which the owners of the business control their company – such controls would amount to de facto nationalization. Capable executives may move to unregulated or foreign companies.

Arguments for a FPSC

Economist Joseph Stiglitz has argued that a government agency should review new financial products.^[149] A financial products safety commission concept was included in the plan outlined by President Obama and his financial team.^[150]

Arguments against a FPSC

Critics may argue that such a commission would slow financial innovation, adversely impact Wall Street profit, or reduce credit availability if popular products (such as adjustable rate mortgages) are deemed inappropriate for consumers.

If people want U.S. government guaranteed safety, they can put their money in: cash, an FDIC insured account, or in U.S. Treasury securities. The whole point of other securities is to allow people to make their own judgment on risk instead of accepting the opinion of a financial dictator such as FPSC.