6 major provisions of Dodd-Frank
Unpacking the state of the Wall Street Reform and Consumer Protection Act, and how it's designed to prevent another crisis
On July 21, 2010, President Obama signed the Wall Street Reform and Consumer Protection Act, more commonly referred to as the Dodd-Frank Act. Written in the aftermath of the 2008 financial crisis, the Dodd-Frank Act is the most substantial piece of financial reform signed into law since the Great Depression. In essence, the Dodd-Frank Act pioneered a major overhaul of the rules governing the country’s financial system in an attempt to reduce the likelihood of future financial crises. To do so, it put in place stricter regulations on the activities of financial institutions as well as better protections for consumers.
Today, more than six years after its passage, financial regulators are finally nearing the finish line on hundreds of important rules and regulations that the Dodd-Frank Act gave them the responsibility to develop and enforce. Major players, including the Securities and Exchange Commission (SEC), the Commodities Futures Trading Commission CFTC), the Federal Deposit Insurance Corporation (FDIC), and the Consumer Financial Protection Bureau (CFPB) have developed hundreds of new rules that, taken together, limit the amount of risky behavior in the broader financial system.
Even though the Dodd-Frank Act is nearing the end of its implementation phase, Wall Street reform still occupies a central stage in the political arena on both sides of the ideological spectrum—especially in light of the 2016 elections. On the Democratic side, Senator Bernie Sanders and Secretary Hillary Clinton sparred regularly over what needs to be done next to reduce risk in the financial system: according to Sanders, breaking up the biggest banks and re-introducing the Glass-Steagall Act would get the job done in one fell swoop, while Clinton proposed a more targeted set of reforms intended to reduce risk in the “shadow banking” sector. On the Republican side, prescriptions for Wall Street reform ranged from increasing capital standards to re-introducing Glass-Steagall, but more often focused on the need to reduce regulations that are alleged to hurt smaller banks and overall economic freedom and vibrancy.
But first—what are the major components of the Dodd-Frank Act and how do they aim to change our nation’s financial system? Here are six of the most important parts of the law that it's helpful to understand:
1. The Volcker Rule
- WHAT: The Volcker Rule intends to prevent commercial banks from engaging in speculative activities and proprietary trading for profit. In particular, it limits banks’ investments in hedge funds and private equity funds.
- WHY: Commercial banks’ proprietary trading activities played a major role in the 2008 crisis. As a result, the banks experienced losses that placed depositors’ funds—and in turn, taxpayers’ dollars—at risk. By enacting the Volcker Rule, the government aims to regulate this kind of activity to keep depositors’ money safe.
- WHO: The rule is named after former Federal Reserve Chair Paul Volcker, who is an elder statesman of financial matters and encouraged President Obama to include such a measure as part of financial reform.
- WHEN: Regulators finalized the Volcker Rule in April 2014. Banks were required to comply by July 2015.
2. The Consumer Financial Protection Bureau
- WHAT: The CFPB was created as an independent financial regulator to oversee consumer finance markets, including mortgages, student loans, and credit cards. The CFPB can write new rules, supervise certain financial companies, and enforce consumer protection laws through fines and other measures. (For example, the CFPB has already required major credit card issuers to pay hundreds of millions of dollars to consumers for deceptive credit card practices.)
- WHY: Prior to the CFPB’s creation, there was no single authority whose primary responsibility was preventing consumer abuse or predatory practices in financial markets. The CFPB also aims to inform and educate consumers on financial matters, empowering them to take control of their own finances and understand their money’s trajectories.
- WHO: The agency is Senator Elizabeth Warren’s brainchild, but President Obama did not believe she could be confirmed by the Senate to lead it. Instead of Senator Warren, Richard Cordray, the former Attorney General of Ohio, is the CFPB’s first and current director.
- WHEN: The CFPB launched on July 11, 2011.
3. Capital and liquidity requirements
- WHAT: The Federal Reserve set new standards for the amount and type of capital that banks and other depository institutions must have to protect against their exposures. The largest institutions, including Citibank, Bank of America, and Goldman Sachs, will be required to hold up to 9.5 percent of their assets in liquid capital (such as cash, government bonds, or other assets that are deemed to have a very low risk profile). However, some critics say this capital cushion is still far too low for the largest financial institutions.
- WHY: Before the financial crisis, some large financial institutions had leverage ratios of roughly 50 to 1—in other words, they only had $1 in capital to protect against every $50 in liabilities. When the value of mortgage-related assets began to decline, firms’ balance sheets were quickly wiped out and the Federal Reserve was forced to step in to recapitalize them (with the exception of the failure of Lehman Brothers), or else allow further chaos in the financial system and broader economy. The new requirements will help ensure that banks can stay afloat significantly longer in case this happens again, without the drastic government bailouts necessary last time.
- WHEN: A number of rules are going into effect on a rolling basis according to international standards. The largest financial institutions are required to meet the new capital standards by 2019, which means they will have leverage ratios nearer to 10 to 1—far more sustainable than before the financial crisis.
4. The Financial Stability Oversight Council (FSOC) and designations
- WHAT: The FSOC is an interagency group composed of heads and deputies of the Treasury Department and independent financial regulators to identify and monitor risks to the financial system. Its most important initial responsibility is designating systemically important financial institutions (SIFIs)—in other words, large, financially interconnected non-banks like AIG—for enhanced capital standards and regulation by the Federal Reserve.
- WHY: The 2008 financial crisis proved that unsupervised non-banks were deeply engaged in financial activities that could put the broader financial system at risk. The most infamous non-bank bailout was the multinational insurance firm AIG, which required an $180 billion rescue from the federal government after it sold massive amounts of insurance without hedging its investments, as well as sold credit default swaps without adequate collateral or capital reserves.
- WHEN: The first SIFI designations occurred in the summer of 2013 and included AIG, GE Capital, and Prudential Financial. Since then, the FSOC has also designated MetLife for enhanced supervision.
5. Derivatives regulations
- WHAT: The Dodd-Frank Act gave the Securities Exchange Commission and the Commodities Futures Trading Commission authority to regulate “over-the-counter” derivatives trading. (“Over-the-counter” refers to a type of financial trade that is negotiated and carried out by private parties, rather than on a formal exchange, such as the New York Stock Exchange.) The Dodd-Frank Act also mandated that firms buying and selling derivatives need to use clearinghouses to do so. Clearinghouses are intended to reduce overall risk in the market by requiring collateral deposits and monitoring the credit-worthiness of firms engaged in derivatives trades. Clearinghouses are strongly capitalized in order to pay out losses if a firm defaults on its obligations.
- WHY: When large numbers of homeowners defaulted on their mortgages in 2008, institutions with exposure to large amounts of certain types of derivatives linked to mortgages were wiped out, requiring cash infusions from the Federal Reserve to prevent outright collapse. These types of unregulated derivatives allowed too much risk to become distributed opaquely throughout the financial system and helped obscure the fact that system-wide capital reserves failed to match it.
- WHEN: Ongoing. Roughly three-quarters of the 87 new derivatives rules required in the Dodd-Frank Act have been finalized.
6. Too Big to Fail and Living Wills
- WHAT: The Dodd-Frank Act gave the Federal Deposit Insurance Corporation “orderly liquidation authority”—in other words, the ability to wind down a large, failing financial institution as an alternative to bankruptcy. Large banks are also required to create “living wills,” or detailed plans that explain how they would manage their own failure without contaminating the broader financial system.
- WHY: These measures are aimed at preventing market chaos and ensuring the government won’t need to provide another costly bailout in the event that a large financial institution fails. If banks are ultimately unable to submit acceptable plans, they could be required to break into smaller institutions.
- WHEN: Ongoing. Regulators are currently considering whether the largest banks’ living wills are credible plans; in 2014, they sent the banks back to the drawing board after earlier versions were all rejected as inadequate.
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