Dodd-Frank Act Explained: Impact & Key Provisions

The Dodd-Frank Act, or the Wall Street Reform and Consumer Protection Act of 2010, was enacted into law during the Obama administration as a response to the financial crisis of 2008. It was named after its sponsors, US Senator Christopher Dodd and US Representative Barney Frank. The Dodd-Frank Bill sought to introduce significant changes to financial regulation and create new government agencies tasked with implementing the various clauses in the law. The law affected all federal regulatory bodiesFederal Reserve (The Fed)The Federal Reserve is the central bank of the United States and is the financial authority behind the world’s largest free market economy. and almost all parts of the financial services industry.

Provisions of the Dodd-Frank Act

Due to the perceived low regulation and high reliance on large banks, the Dodd-Frank Act aimed to introduce more stringent rules in banking regulation to avoid a re-occurrence of the 2008 Financial Crisis. To achieve this, the Act established the Financial Stability Oversight Council (FSOC) to address issues affecting the financial industry. The council was created alongside the Office of Financial Research under Title I of the Act. The two agencies work closely to monitor systemic risk and research the state of the economy.

The FSOC comprises ten voting members, nine of whom are federal regulators. The remaining voting member is the Treasury Secretary, who also acts as the Chair to the council. The council also includes five non-voting members. It can impose stricter regulations on institutions that are viewed as “too big to fail” and likely to pose systemic riskSystemic RiskSystemic risk can be defined as the risk associated with the collapse or failure of a company, industry, financial institution or an entire economy. It is the risk of a major failure of a financial system, whereby a crisis occurs when providers of capital lose trust in the users of capital. It is responsible for promoting market discipline, identifying threats to the financial stability of the US, and managing emerging risks that threaten the financial system.

The Office of Financial Research (OFR) works alongside the FSOC by providing necessary data on the operations of the financial services industry. The OFR is authorized to obtain data from any institution in the industry to help in discharging its functions. It also issues guidelines to standardize how firms report data. The head of OFR is a Presidential appointee, subject to approval by the US Senate.

The Dodd-Frank law also established the Consumer Financial Protection Bureau (CFPB) to protect consumers from large unregulated financial institutions. The law also consolidated the functions of other agencies, including the Department of Housing and Urban Development, the Federal Trade Commission, and the National Credit Union Administration. The CFPB is charged with preventing risky business practices that are likely to hurt consumers. The CFPB requires lenders to disclose information to consumers in a way that is easy to read and conceptualize.

Another key provision in the Dodd-Frank Act is the Volcker rule, which prohibits banks from making high-risk speculative investments SpeculationSpeculation is the buying of an asset or financial instrument with the hope that the price of the asset or financial instrument will increase in the future.that may disadvantage their customers. The rule is named after former Federal Reserve Chairman, Paul Volcker, who initiated it as a response to the financial crisis. According to the Volcker rule, banks are required to set up internal compliance mechanisms that are subject to supervision by regulatory agencies.

The rule limits banks from owning more than 3% of the total ownership interests in a private equity fund or hedge fund because they are considered too risky. Institutions tasked with implementing the Volcker rule include the Office of Comptroller of the Currency, the Federal Reserve System Board of Governors, the United States Securities and Exchange Commission, and the Federal Deposit Insurance Corporation.

The Dodd-Frank Act also introduced new measures to regulate risky derivatives such as Credit Default Swaps (CDS)Credit Default SwapA credit default swap (CDS) is a type of credit derivative that provides the buyer with protection against default and other risks. The buyer of a CDS makes periodic payments to the seller until the credit maturity date. In the agreement, the seller commits that, if the debt issuer defaults, the seller will pay the buyer all premiums and interest. The CDS were traded over the counter prior to the financial crisis, and they were widely blamed for contributing to the crisis. The law created centralized exchange markets for swaps trading to reduce the possibility of default among traders. It also required greater disclosure to the public on swap trading to reduce the risks it posed to the public.

The act was criticized for failing to address the role of government policies in causing the financial crisis. It was largely political pressure on banks that led to an abundance of risky subprime mortgages – which led to the creation of credit default swaps as a means of handling the massive amount of high-risk mortgages.

The Financial Choice Act

The Financial Choice Act was introduced in June 2017, with the aim of making changes to the Dodd-Frank Act, which was very unpopular within the financial services industry and disliked by many individual investors as well, many of whom feel overly restricted by Dodd-Frank in their investing activities. The bill was submitted to the Congress following an executive order signed by President Donald Trump in February 2017, directing regulators to review the Dodd-Frank Act and present a report on possible reforms.

One of the proposed changes to the Dodd-Frank law is to reduce the powers of the Consumer Financial Protection Bureau and the Securities and Exchange Commission (SEC)Securities and Exchange Commission (SEC)The US Securities and Exchange Commission, or SEC, is an independent agency of the US federal government that is responsible for implementing federal securities laws and proposing securities rules. It is also in charge of maintaining the securities industry and stock and options exchanges. The Act also gives the President of the United States the power to remove the directors of the CFPB and the Federal Housing Finance Agency (FHFA) that is charged with overseeing the mortgage market.

Impact of the Dodd-Frank Act

The Dodd-Frank Act was enacted with the aim of preventing a reoccurrence of the financial crisis that almost crippled the United States’ financial system. Proponents of the law argue that the law has made remarkable progress in regulating financial institutions, including those that were viewed as “too big to fail.” The creation of new regulatory agencies like the CFPB and the FSOC has made it possible to more closely monitor the operations of banks and protect consumers.

However, the critics of the law insist that it will hinder the competitiveness of US financial companies vis-a-vis foreign companies. In fact, one of the unintended consequences of Dodd-Frank has been many US investors, unhappy with over-regulated US brokerage firms, being driven to trade through overseas firms.

Critics of Dodd-Frank further argue that the regulatory measures particularly overburden small financial institutions that did not contribute to the crisis. Critics also claim that the low interest rates resulting from the financial crisis have affected the profitability of small banks, making it nearly impossible for them to sustain their operations.

Whether the Dodd-Frank Act was good regulatory legislation or one of the most onerous government control grabs in history and an act that has only served to weaken the US economy remains a subject of controversy.

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