By ADAM HAYES
Updated September 08, 2022
Reviewed by
Fact checked by
What
Is the Dodd-Frank Wall Street Reform and Consumer Protection Act?
The Dodd-Frank Wall Street
Reform and Consumer Protection Act is legislation that was passed by the U.S.
Congress in response to financial industry behavior that led to financial
crisis of 2007–2008. It sought to make the U.S. financial system safer for
consumers and taxpayers.
Named for sponsors Sen.
Christopher J. Dodd (D-Conn.) and Rep. Barney Frank (D-Mass.), the act contains
numerous provisions, spelled out over 848 pages, that were to be implemented
over a period of several years.1
KEY TAKEAWAYS
- The Dodd-Frank Act targeted financial
system sectors that were believed to have caused the 2007–2008 financial
crisis.
- Leading up to 2007, lax regulations led to
extremely risky lending practices, which caused a housing sector bubble
that ultimately burst and drove the global crisis, the need for public
bailouts of financial institutions, and recession.
- Those institutions seen as responsible
included banks, insurance companies, investment banking firms, mortgage
lenders, and credit rating agencies.
- Critics of the law argue that the
regulatory burdens it imposes could make U.S. firms less competitive than
their foreign counterparts.2
- In 2018, Congress passed a new law that
rolled back some of Dodd-Frank’s restrictions.3
Understanding
the Dodd-Frank Act
The Dodd-Frank Wall Street
Reform and Consumer Protection Act is a massive piece of financial
reform legislation that was passed in 2010, during the Obama
administration.
Commonly known as the
Dodd-Frank Act, or Dodd-Frank, it established a number of new government
agencies tasked with overseeing the various components of the law and, by
extension, various aspects of the financial
system.
The 2007-2008 financial
crisis is perhaps the worst economic catastrophe to befall the country (and
world) since the Wall Street crash in 1929. Broadly speaking, it was caused by
the greed-driven behavior and lax oversight of financial institutions.
The loosening of financial
industry regulations in the decades leading up to 2007 allowed various types of
institutions in the U.S. financial services industry to lend money in ways that
were riskier than ever before. The housing sector in particular experienced
massive growth that couldn't be supported.
The bubble burst, sending the
banking industry and global stock markets into a downfall. It created the worst
global recession in generations.
Dodd-Frank was created to
keep anything similar from ever happening again.
The Dodd-Frank Wall Street
Reform and Consumer Protection Act was intended to prevent another financial
crisis like the one in 2007–2008.
Components
of the Dodd-Frank Act
Here are some of the law’s
key provisions and how they work:
- Financial Stability: Under the Dodd-Frank Act, the Financial
Stability Oversight Council and the Orderly Liquidation Authority
monitor the financial stability of major financial firms. The failure of
these companies (deemed too big to
fail) could have a serious negative impact on the U.S. economy. The
law also provides for liquidations or restructurings via the Orderly
Liquidation Fund. This fund was established to assist with the dismantling
of financial companies that have been placed in receivership to prevent
tax dollars from being used to prop up such firms. The council has the
authority to break up banks that are considered so large as to pose systemic
risk. It can also force banks to increase their reserve requirements.1 Similarly,
the new Federal
Insurance Office was tasked with identifying and monitoring
insurance companies also felt to be too big to fail.4
- Consumer
Financial Protection Bureau: The Consumer
Financial Protection Bureau (CFPB), established under Dodd-Frank,
was given the job of preventing predatory mortgage lending and helping
consumers to understand the terms of a mortgage before agreeing to it.
This reflected the widespread sentiment that the subprime
mortgage market was the underlying cause of the 2007–2008 catastrophe.
The CFPB deters mortgage brokers from earning higher commissions for
closing loans with higher fees and/or higher interest rates. It requires
that mortgage
originators not steer potential borrowers to the loan that will
result in the highest payment for the originator.5 The CFPB also
governs other types of consumer lending, including credit and debit cards,
and addresses consumer complaints. It requires lenders, excluding automobile
lenders, to disclose information in a form that is easy for consumers to
read and understand. Such an example is the simplified terms now on credit
card applications.6
- Volcker
Rule: The Volcker Rule restricts
how banks can invest, limits speculative trading, and eliminates proprietary
trading. Banks are not allowed to be involved with hedge funds or
private equity firms, which are considered too risky. To minimize possible
conflicts of interest, financial firms are not allowed to trade
proprietarily without sufficient "skin in the game.”7 The Volcker
Rule is clearly a push back in the direction of the Glass-Steagall
Act of 1933, which first recognized the inherent dangers of
financial entities extending commercial and investment banking services at
the same time.8 The act also contains a provision for
regulating derivatives,
such as the credit
default swaps that were widely blamed for contributing to the
2007–2008 financial crisis. Dodd-Frank set up centralized exchanges for
swaps trading to reduce the possibility of counterparty default. It
required greater disclosure of swaps trading information to increase
transparency in those markets.1 The Volcker Rule also regulates
financial firms’ use of derivatives in an attempt to prevent “too big to
fail” institutions from taking large risks that might wreak havoc on the
broader economy.7
- Securities and Exchange Commission (SEC) Office of Credit Ratings: Dodd-Frank
established the SEC Office of Credit Ratings because credit rating agencies
had been accused of giving out misleadingly favorable investment ratings
in the lead up to the financial crisis. The office is charged with
ensuring that agencies provide meaningful and reliable credit ratings of
the businesses, municipalities, and other entities that they evaluate.9
- Whistleblower
Program: Dodd-Frank also
strengthened and expanded the existing whistleblower program promulgated
by the Sarbanes-Oxley
Act (SOX) of 2002. Specifically, it established a mandatory
bounty program under which whistleblowers can
receive from 10% to 30% of the proceeds from a litigation settlement;
broadened the scope of a covered employee by including employees of a
company’s subsidiaries and affiliates; and extended the statute of
limitations under which whistleblowers can bring forward a claim against
their employer from 90 to 180 days after a violation is discovered.10
The
Economic Growth, Regulatory Relief, and Consumer Protection Act
When Donald Trump was elected
president in 2016, he pledged to repeal Dodd-Frank. Siding with critics, the
U.S. Congress passed the Economic Growth, Regulatory Relief, and Consumer
Protection Act, which rolled back significant portions of the Dodd-Frank Act.
It was signed into law by
then-President Trump on May 24, 2018.3 These are some of the provisions of
that law, and some of the areas in which previous standards were loosened:
- The new law eased the Dodd-Frank
regulations for small and regional banks by increasing the
asset threshold for the application of prudential standards, stress test requirements,
and mandatory risk committees.3
- For institutions that have custody of
clients’ assets but do not function as lenders or traditional bankers, the
new law provided for lower capital
requirements and leverage ratios.3
- The new law exempted escrow requirements
for residential mortgage loans held by a depository institution or credit
union under certain conditions. It also directed the Federal Housing
Finance Agency (FHFA) to set up standards for Freddie Mac and Fannie
Mae to consider alternative credit scoring methods.3
- The law exempted lenders with assets of
less than $10 billion from requirements of the Volcker Rule and imposed
less stringent reporting and capital norms on small lenders.3
- The law required that the three major
credit reporting agencies allow consumers to freeze their
credit files free of charge as a way of deterring fraud.3
After Joseph Biden was
elected president in 2020, the CFPB focused on rescinding rules from the Trump
era that were in direct conflict with the charter of the CFPB.
In June 2021, President
Biden, along with the U.S. Department of Education and support from the CFPB,
canceled more than $500 million of student loan debt. The CFPB has strengthened
its oversight of for-profit colleges to tamp down on predatory student loan
practices.
The Biden administration has
also announced its intent to reestablish rules against other predatory lending,
such as payday
loans. Additionally, subprime
auto loan practices will be addressed by the CFPB.
Criticism
of the Dodd-Frank Act
Proponents of Dodd-Frank
believed that the law would prevent the economy from experiencing a crisis like
that of 2007–2008 and protect consumers from many of the abuses that contributed
to the crisis.
Detractors, however, have
argued that the law could harm the competitiveness of U.S. firms relative to
their foreign counterparts. In particular, they contend that its regulatory
compliance requirements unduly burden community banks and smaller financial
institutions, despite the fact that they played no role in causing the
financial crisis.2
Such financial world notables
as former Treasury Secretary Larry Summers, Blackstone Group L.P. (BX) CEO
Stephen Schwarzman, activist Carl Icahn, and JPMorgan Chase & Co. (JPM)
CEO Jamie Dimon also argue that, while each institution is undoubtedly safer
due to the capital constraints imposed by Dodd-Frank, the constraints make for
a more illiquid market
overall.1112
The lack of liquidity can be
especially potent in the bond market, where all securities are not marked to market and
many bonds lack a constant supply of buyers and sellers. The higher reserve requirements
under Dodd-Frank mean that banks must keep a higher percentage of their assets
in cash. This decreases the amount that they are able to hold in marketable
securities.1
In effect, this limits the
bond market-making role that banks have traditionally undertaken. With banks
unable to play the part of a market maker,
prospective buyers are likely to have a harder time finding counteracting
sellers. More importantly, prospective sellers may find it more difficult to
find counteracting buyers.
What Was the Purpose of the
Dodd-Frank Act?
Dodd-Frank was intended to
curb the extremely risky financial industry activities that led to financial
crisis of 2007–2008. Its goal was, and still is, to protect consumers and
taxpayers from egregious behavior such as predatory lending.
Is the Dodd-Frank Act Still
in Effect?
Yes, it is. However, its
regulatory strength was diluted with the passage of the Economic Growth,
Regulatory Relief, and Consumer Protection Act in 2018. Still, certain aspects,
such as the bank stress tests it called for, are in use today. The Federal
Reserve publishes stress test results regularly.13
What Are Some Criticisms of
the Dodd-Frank Act?
Detractors of the Dodd-Frank
Act have argued that the law could harm the competitiveness of U.S. firms
relative to their foreign counterparts. In particular, critics contend that its
regulatory compliance requirements unduly burden community banks and smaller
financial institutions—despite the fact that they played no role in causing the
financial crisis.2 Several financial world notables argued that, while
each institution is undoubtedly safer due to the capital constraints imposed by
Dodd-Frank, the constraints also make for a more illiquid market overall.1112
Could the Dodd-Frank Act
Affect the Bond Market?
The potential lack of
liquidity due to the higher reserve requirements under Dodd-Frank means that
banks must keep a higher percentage of their assets in cash. This decreases the
amount that they are able to hold in marketable securities. In effect, this
limits the bond market-making
role that banks have traditionally undertaken. With banks unable to play the
part of market maker, prospective buyers are likely to have a harder time
finding counteracting sellers. More importantly, prospective sellers may find
it more difficult to find counteracting buyers.
The
Bottom Line
The Dodd-Frank Act, enacted
in 2010, was a direct response to the financial crisis of 2007–2008 and the
ensuing government bailouts under the Troubled
Asset Relief Program (TARP).
This law established a wide
range of reforms throughout the entire financial system, with the purpose of
preventing a repeat of the 2007–2008 crisis and the need for further government
bailouts. The Dodd-Frank Act also included additional protections for
consumers.
Although the Trump
administration reversed and weakened several aspects of the Dodd-Frank Act,
particularly those affecting consumers, the Biden administration intends to
reestablish and strengthen the previous reversals to protect individuals who
may be subject to predatory lending practices in industries such as for-profit
education and automobiles.
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