After the financial crisis of 2008 led to the largest worldwide economic recession since the Great Depression, legislators were determined to change the system to ensure that wouldn’t happen again. In 2009, Senator Barney Frank and Representative Chris Dodd proposed the Dodd-Frank Wall Street Reform and Consumer Protection Act, and President Obama signed it into law in 2010. The act was a major overhaul in the United States’ financial regulation system; it established several new government agencies and transferred the powers of others in order to strengthen banking regulations, prevent banks from becoming “too big to fail,” and protect consumers against unfair practices.
What is the background that led to Dodd-Frank?
In 2008, the so-called “subprime mortgage bubble” was allowing banks to make high-risk mortgage loans to low- and middle-income homeowners. These loans were then bundled and sold as low-risk securities, but lax criteria and aggressive lending practices eventually led to the “bubble” bursting as homeowners began becoming delinquent on their payments. As a result, the bundled, mortgage-backed securities plummeted in value, and large banks’ investors began emptying their accounts, which entirely destabilized the banks because they weren’t receiving the capital they relied on to function. Not only did this lead to the bankruptcy of major banking institutions like Lehman Brothers and Bear Stearns, but the ramifications rippled throughout the economy as the stock market crashed, credit markets froze, and large companies like General Electric couldn’t access the funds they needed to pay their employees and perform basic operating functions.
Other large banks found themselves facing failure, but because they were deemed “too big to fail,” the government was expected to bail them out because their failure would have a devastating impact on the economy. So the government paid hundreds of billions of dollars to help stabilize major banks like Bank of America and JPMorgan Chase. Still, the bailout was a temporary measure, and it became clear that regulatory legislation was necessary to prevent another future crisis and curb the growth of these big banks that were “too big to fail.” As Bernie Sanders put it, banks that are too big to fail are too big to exist.
What is Dodd-Frank’s role and what are its major provisions?
In a nutshell, the Dodd-Frank Act changed the way banks are regulated by creating several new agencies to enable stronger oversight, establishing systems of increased transparency into banks’ actions and investments, eliminating taxpayer-funded bailouts for banks, and ending proprietary trading in financial institutions.
In its own words, the Dodd-Frank Act intends to “promote the financial stability of the United States by improving accountability and transparency in the financial system, to end ‘too big to fail’, to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes.”
Specifically, the Dodd-Frank Act established important agencies like:
- The Financial Stability Oversight Council, which identifies threats to economic stability in the United States and responds to them as appropriate. For instance, it reports to Congress on the financial system and can vote to place any financial institution under the supervision of the Federal Reserve if it looks like it poses a threat. Moreover, banks with more than $50 billion in assets must submit certified reports and pass annual tests that determine whether they can survive a major crisis should another strike.
- The Office of Financial Research, which collects data from banks and can subpoena any relevant information from any financial institution in order to support regulations that ensure financial stability
- The Consumer Financial Protection Bureau, which regulates financial consumer products to make sure that banks are being fair and transparent with their offerings and providing them to consumers in such a way that they understand exactly what they’re buying. The Bureau also protects against deceptive and abusive practices.
The Dodd-Frank Act also eliminated the Office of Thrift Supervision and instead split its powers over holding companies, state savings associations, and other thrifts between the Federal Reserve, FDIC, and Office of the Comptroller of the Currency. This was meant to streamline regulation and reduce competition among regulators.
Another major provision of the Dodd-Frank Act requires banks to keep more of their assets in cash and securities rather than in loans, because they can be easily liquidated in case consumers attempt to pull money from the bank again, as they did in 2008. Holding larger reserves also makes it easier for banks to absorb loan losses if necessary. Finally, the Volcker Rule makes it illegal for banks to own a hedge fund or engage in proprietary trading—with depositors’ money rather than their own—essentially separating investment banks from commercial banks. This rule eliminates unnecessary risk associated that comes with making speculative trades using consumers’ funds.
Altogether, the Dodd-Frank Act lays out sixteen different “titles,” which amount to more than 200 new rules for regulators and commission tens of new studies and reports. By keeping a closer watch on big banks’ reserves and investments and by eliminating their risky behaviors as much as possible, the government hopes to ensure the stability of the financial ecosystem.
What is the outlook for the Dodd-Frank Act?
Even though the Dodd-Frank Act has succeeded in stabilizing banks, and no major American banks have been significantly affected by economic pressures such as plummeting oil prices, it’s likely that the Act won’t survive in its current form. In February 2017, President Trump signed an order broadly instructing a rollback of banking regulations, many of which are covered by the Dodd-Frank Act. Trump and other critics of the act claim that it limits growth on Wall Street by limiting loans and stifles small and mid-sized banks. Loosening the regulations would give banks greater flexibility for how they deal with their finances—but, of course, financial flexibility, some might argue, is what led to the 2008 crisis in the first place. Trump also hopes to replace the Consumer Financial Protection Bureau chair and eventually eliminate the agency altogether.