What Is the Dodd-Frank Act?

What Is the Dodd-Frank Act?

The Dodd-Frank Act, named after its co-sponsors, Sen. Chris Dodd and Rep. Barney Frank, aimed to regulate the financial industry and protect consumers from the ramifications of the 2007 to 2008 financial crisis.

The economic crisis was due, in part, to the repeal of the Glass-Steagall Act, which was put in place in the wake of the Great Depression. The 1933 law prohibited commercial banks from also operating as investment banks. However, that law was repealed in 1999, allowing financial institutions to make risky investments with customer deposits.

Additionally, mortgage lenders made trillions of dollars worth of loans to high-risk borrowers, which were repackaged as mortgage-backed securities, a type of derivative, and given a low-risk rating from credit rating agencies like Moody’s and S&P Global Ratings. Banks then borrowed heavily against these assets, so when the housing bubble burst, high-risk borrowers defaulted on their loans, resulting in hundreds of banks failing.

Some of the primary goals of the Dodd-Frank Act were to increase supervision of the financial industry, identify potential risks that could impact the entire economic system and protect consumers from these risky investments made by banks.

What Does the Dodd-Frank Act Do?

The Dodd-Frank Act includes several provisions. Here are some of the main objectives it attempted to accomplish:

• Created the Consumer Financial Protection Bureau (CFPB): The CFPB is a consolidation of multiple federal consumer watchdog agencies. It oversees credit reporting agencies, consumer and payday loans, banking fees, credit and debit cards, and more.
• Created other federal agencies and councils: The act also established the Financial Stability Oversight Council to identify risks that affect the whole system, the Federal Insurance Office to oversee potential risks in the insurance industry, and the Office of Financial Research to collect and standardize financial data and measure and analyze financial risks.
• Increased credit rating oversights: The law created the Office of Credit Ratings, which, under the supervision of the Securities and Exchange Commission, regulates credit rating agencies and ensures accurate methodology.
• Developed the Volcker rule: In the spirit of the Glass-Steagall Act, Congress prohibited banks from engaging in proprietary trading or investing in or sponsoring hedge funds or private equity funds.
• Regulates risky trades: High-risk derivatives that helped precipitate the financial crisis now have tighter regulations. Additionally, the Securities and Exchange Commission and the Commodity Futures Trading Commission are tasked with identifying excessive risk in the derivative market and notifying lawmakers before another major crisis happens.
• Provides protections for whistleblowers: Insiders that report wrongdoing by financial institutions are now protected against retaliation from their employer and may also receive financial compensation.

Is the Dodd-Frank Act Still in Effect?

The motivation behind the Dodd-Frank Act is understandable, but it’s not without controversy.

After the law was passed, it was heavily criticized by the financial industry, with firms arguing that it harmed their competitiveness with foreign financial institutions. Critics also contended that compliance with the law’s provisions created undue burdens for small banks that played no role in the events that caused the financial crisis.

While most of the Dodd-Frank Act remains in effect, legislators responded to lobbying from the financial industry by rolling back some of the law’s provisions in 2018. In particular, here are some of the main changes made by the Economic Growth, Regulatory Relief, and Consumer Protection Act:

• Increased the asset threshold for banks that are required to conduct stress tests and maintain risk committees, easing regulations on smaller banks.
• Exempted lenders with assets of less than $10 billion from the Volcker rule.
• Lowered capital requirements and leverage ratios for financial institutions that act as custodians for clients’ assets but don’t function as traditional banks or lenders.
• Loosened reporting and capital norm requirements for small lenders.

How the Dodd-Frank Act Helps Consumers

The crux of the Dodd-Frank Act is to help maintain economic stability, which benefits consumers, particularly by preventing risky investments from financial institutions from causing another financial crisis like the one that affected economies around the world.

Additionally, the CFPB provides important financial education and resources and also identifies and takes legal action against companies that behave improperly or even illegally to the detriment of their customers. The agency maintains a civil penalty fund worth nearly $1.5 billion, designed to provide compensation for consumers harmed by financial institutions.