Widely considered the most significant financial regulatory reform since the Great Depression, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) instantly became a debated political battle in Washington. Dodd-Frank legislation aims to prevent another disastrous financial crisis such as the financial collapse in 2008.
What Does Dodd-Frank Do?
Dodd-Frank is an effort to cover gaps in financial regulation, regulate the financial markets that played a role in the 2008 financial crisis, regulate commercial bank investments, and increase public confidence in the financial system.
Addressing gaps in financial regulation is the creation of a Financial Stability Oversight Council (FSOC). The council identifies and reduces risks and threats to the entire financial system, putting the responsibility to recommend regulations in the hands of one agency. This aims to prevent threats to the economy from the financial system from “slipping through the cracks” through several different regulators.
One of the markets involved in the 2008 Financial Crisis Dodd-Frank regulates is the Asset backed securities market. Asset backed securities are when a banker wants to sell many mortgages or other assets together as one investment or “security”. Market reforms in this area attempt to prevent bankers from putting together bad mortgages (mortgages that are not likely to be repaid) or other assets into a security and selling them without any consequence if the security fails (the mortgages are not payed).
Dodd-Frank requires that these security bankers retain 5% of the overall risk of the security. This provision strives to correct an area of the financial sector that caused the 2008 financial crisis where security bankers placed mostly faulty mortgages into a security then quickly sold them with no concern of whether the security would fail.
Think of this regulation as the scene in the Oscar award winning movie “The Big Short” where a CDO (Collateralized Debt Obligation) manager (a security bundler) describes how he has an incentive to sell securities that he knows will fail and profits excessively from them encouraging the entire industry to create asset backed securities that would eventually crash the economy. With the Dodd-Frank regulation, If the asset backed security fails, the bundler is responsible for at least 5% of the fallout unless certain conditions are met.
Greater regulation of derivatives is another provision in Dodd-Frank. Think of derivatives as “bets” on the price on the future value of a stock or an asset backed security. The derivatives market can also operate as a form of gambling for investment bankers as derivatives betting on the amount of hurricanes that will make landfall in a year or what the average temperature will be in a certain month are available investments on Wall Street. While the derivatives market may seem like a casino for investment bankers, derivatives do play a role in reducing risk if used correctly. Dodd-Frank requires that both sellers and large buyers in the derivatives market be registered and must maintain a certain amount of capital (available money) to protect the buyer or seller if the investment fails.
Preventing commercial banks from investing in certain types of higher risk investments through the “Volcker Rule” is one of the most controversial aspects of Dodd-Frank. The Volcker Rule, which will not fully go into effect until July 21st, 2017, requires that commercial banks not use their own money for investments in hedge funds (an investment to reduce the risk of price movements) and riskier investments such as securities and derivatives. By preventing risky investments by commercial banks, the Volcker Rule attempts to prevent risk to the economic system before it can be created.
Boosting investor trust and confidence in the financial system was a necessity for economic recovery from the financial crisis which Dodd-Frank attempts to address through regulating credit rating agencies.
Conflicts of interest in credit rating agencies are put under more stringent regulations. Credit rating agencies now must be separated from business that involves marketing or sales attempting to prevent agencies from having a financial incentive to give investments high ratings. In other words, Dodd-Frank regulation tries to stop bankers from essentially bribing credit agencies to give their investments high ratings.
Reforms addressing this were put in place after fraudulent activities by credit rating agencies assisted in causing the financial crisis by inexplicably giving high ratings to securities that eventually failed crashing the U.S. economy. Through these regulatory changes, Dodd-Frank attempts to instill confidence by allowing investors to trust both the investments security and their ratings to make an informed decision whether or not to invest.
Opponents of Dodd-Frank
Opponents of Dodd-Frank include many Republicans including Texas Congressman Jeb Hensarling. He argues: "Housed at the Federal Reserve, the CFPB has the ability to put entire industries out of business with the snap of its fingers. Its unelected director can simply declare financial products "abusive" and outlaw them without Congressional approval” (full statement here).
Congressman Hensarling is introducing, with the support of House Republicans, the Financial CHOICE Act to effectively repeal Dodd-Frank financial regulation. A main purpose of the Act is to change regulatory environment which, in many Republicans’ opinion, gives large banks an advantage over small banks due to their ability to comply with complex Dodd-Frank directives while small banks do not have the compliance resources necessary. Another main complaint about Dodd-Frank is a view that through strict regulation, the federal government is overstepping into financial markets along with the economic liberty and freedom of the financial industry.
Supporters of Dodd-Frank
Many Democrats argue that repealing Dodd-Frank would be a dangerous step backwards into the “wild west” regulatory environment leading up to the 2008 financial crisis according to recently resigned Democratic National Committee chair Debbie Wasserman Schultz (full statement here). In addition, supporters claim the high regulatory cost is low in comparison to the cost of a financial crisis which was estimated to cost the U.S. economy $14 trillion in the 2008 crisis.
Six years after Dodd-Frank was signed into the law, financial regulation and financial crisis prevention is still a contentious issue on Capitol Hill. Check your elected officials and views and votes on Dodd-Frank and financial regulation at Votesmart.org.
Aaron Goodman is a student at Carleton College. He interned with Vote Smart in the Research Department. For more information on internship opportunities with Vote Smart, contact us at firstname.lastname@example.org or by calling 1-888-VOTE-SMART.