The Dodd–Frank Financial Reform
Kennedy School, Harvard University
The Issue:After the U.S. mortgage crisis of 2007 led to the severe global financial crisis and global recession of 2008-09, there was strong popular support for strengthening financial regulation in the United States, with the goal of reducing the frequency and severity of such financial crises in the future. Ten years later, there is a movement to roll back the regulations that were put in place. While all sides agree there is scope for improvement, there are significant disagreements on the extent and direction of needed reforms. Federal Reserve Chairwoman Janet Yellen strongly defended the financial regulations enacted in the wake of the financial crisis during her annual speech at the Federal Reserve's Jackson Hole conference in August 2017 saying that: "The balance of research suggests that the core reforms we have put in place have substantially boosted resilience without unduly limiting credit availability or economic growth." At the same time, some believe that the problem is too much financial regulation rather than too little. In response to an executive order by President Trump, the Treasury Department issued detailed recommendations in June to revise banking regulations. And, the House of Representatives approved the Republican-sponsored Financial-Choice Act, which would undo many of the key provisions instituted in the wake of the financial crisis.
While all sides agree there is scope for improvement, there are significant disagreements on the extent and direction of needed reforms.
- Financial reform legislation was proposed by President Barack Obama in June 2009, refined by Congressman Barney Frank and Senator Chris Dodd in December, and then passed by the Congress in its ultimate form and signed by the president in July 2010 as the Dodd–Frank Wall Street Reform and Consumer Protection Act.
- The law works to prevent banking bailouts or deposit guarantees from burdening the taxpayer or encouraging "moral hazard" which is when awareness of the safety net encourages excessive risk-taking. For instance, there is moral hazard when large financial institutions take excessive risks under the assumption that the government will deem them "too big to fail" and will come to their rescue in order to prevent a more widespread financial sector collapse. The banking provisions under the financial reform include higher capital requirements to make sure the bank is unlikely to get over-extended. The Federal Reserve in 2014 announced an extra “capital surcharge” on the 8 biggest banks. And provisions also require regular stress tests, for financial institutions with above $50 billion in assets to try to make sure that the cushion is thick enough to protect the solvency of the bank even in the event of major unforeseen adverse shocks. If a bank has trouble under the stress tests, it may be required to hold off from share buybacks or dividend payouts and, if necessary, to raise additional capital financing.
- The law extends supervision beyond banks to other financial institutions that are significant to the health of the financial system. Over time, the financial system has evolved to encompass many important players beyond traditional banks. Dangers come, not just from commercial banks, but rather from investment banks and such “non-bank” financial institutions as money market mutual funds, hedge funds, and even large international insurance companies. This was the case in the 2008 financial crisis. However, regulations prior to the crisis had not evolved apace with this development, leaving important financial players outside the purview of financial oversight. In response, Dodd-Frank tasks government regulators (in the form of the Financial Stability Oversight Council, or FSOC) with designating Systemically Important Financial Institutions or SIFIs, who are then made subject to some of the same sorts of regulation as banks. It gives government regulators Orderly Liquidation Authority, which is the power to resolve a SIFI if it becomes necessary, without burdening the taxpayer, whereas previously the FDIC only had authority to wind up commercial banks. To facilitate resolution of large financial institutions that fail, they are required to submit “living wills” ahead of time.
- Dodd-Frank also established the Consumer Financial Protection Bureau to give households the same sort of protection against misleading or abusive provision of financial services as they have for consumer goods. The CFPB was originally proposed by now Senator Elizabeth Warren in response to the 2007-09 subprime mortgage crisis. (But some had warned of the lack of regulatory protection for homeowners against unscrupulous lending practices even before the crisis, for instance Fed Governor Edward Gramlich in 2007.) Proponents of Dodd-Frank consider the activities of the CFPB so far to have been among the most successful aspects.
- The reform improved regulation and transparency of derivatives, particularly by having standardized derivatives traded on centralized exchanges. These are just four major examples of ways in which Dodd-Frank works to reduce future crises.
- Some on the Left seem to believe that Dodd-Frank has accomplished little because it does not include some sweeping reforms that they want, particularly breaking up banks into pieces so small that they won’t be “too big to fail” and bringing back the 1933 Glass-Steagall Act’s separation of investment banks from commercial banks.
- Many on the Right believe that Dodd-Frank constitutes highly burdensome government regulation. They point out that banks have had to dedicate a lot of time and money to demonstrating compliance with the regulations, and that the bureaucratic burden may fall too heavily on smaller banks. Some estimates have tallied costs in the order of $36 billion but compliance costs are hard to quantify. Other critiques claim that bank lending and therefore growth has been held back in recent years, even though interest rates have been at record lows (see for instance JPMorgan Chase CEO Jamie Dimon's 2016 letter to investors, pages 24-25).
- The Trump administration and Congressional Republicans are spearheading efforts to roll back different aspects of Dodd-Frank. During the presidential campaign, Donald Trump gave many voters the general impression that he was on their side against the big banks. But shortly after taking office he said he was going to “do a number on Dodd-Frank,” following up on earlier promises to “dismantle” it. His Treasury began the process in June 2017 by releasing a report on banking. Its recommendations included weakening the yearly stress tests, the capital and liquidity requirements for the largest international banks, and the Volcker Rule, which prevents banks from engaging in proprietary trading, i.e., speculative bets on their own account. (The next installment from Treasury is expected to propose rolling back the designation of non-bank SIFIs.) Also in June, Congressional Republicans advanced legislation to roll back various aspects of Dodd-Frank.
- It is easy to agree that Dodd-Frank can be improved upon and even easier to acknowledge that no financial regulation will ever eliminate completely the boom-bust cycle that seems to be an intrinsic element of human social psychology. But it is insufficiently recognized that many shortcomings arise because some features that were in the originally proposed legislation were then cut out or neutered by Congressional opponents of regulation. For instance, the law could be strengthened by the inclusion of car dealers from CFPB regulation. Auto-dealers, lobbied successfully to get themselves exempted from regulation by the CFPB, allowing the resumption of some abusive lending practices that resemble the sub-prime mortgages which played such a big role in the 2008 financial crisis. Another example would be the "retention" rule telling banks and other mortgage originators to keep some "skin in the game." The Dodd-Frank law was supposed to require them to retain on their books at least 5 percent of the housing loans they made, rather than repackaging every last mortgage and reselling it to others. The reason is that the originators need to have an incentive to take care that the borrowers would reasonably be able to repay the loans. Under heavy pressure from Congress, that requirement was gutted in 2014. Similarly, the addition of rules for a 20 percent minimum down payment on housing loans would help reduce financial risk. Such a requirement was supposed to be part of Dodd-Frank, but the regulators were forced to back down in 2013. Virtually every American politician in both parties still acts as though the goal should be to get as many people into as much housing debt as possible, even if many will not be able to repay the loans and even after such practices caused the worst financial crisis and recession since the 1930s. Finally, adequate support for regulatory agencies would help strengthen the system. Congress has refused to give regulatory authorities such as the SEC (Securities and Exchange Commission) and CFTC (Commodities Futures Trading Commission) budgets commensurate with their expanded regulatory responsibilities, in a deliberate effort to hamper enforcement.
What this Means:
The Dodd-Frank Act has many solid features that help make the U.S. financial system more resistant to financial crises. They include higher capital requirements for banks, the inclusion of other systemically important companies, and consumer financial protection. But the legislation is under increasing assault from those who seek to peel back regulation. At the same time, some who passionately favor tough financial regulation have failed to recognize the important contribution made by Dodd-Frank and what would be lost if it were rolled back. As Federal Reserve Vice Chairman Stanley Fischer observed (to the Financial Times, August 16, 2017), “now after 10 years everybody wants to go back to a status quo before the great financial crisis. And I find that really, extremely dangerous and extremely short-sighted.”