Table of Contents
- 1 Introduction to Dodd-Frank Act
- 2 Modus-operandi and critical provisions of the Dodd-Frank Act
- 3 Shortcomings of the Dodd-Frank Act
- 4 Changes in the Dodd-Frank Act
Introduction to Dodd-Frank Act
The Dodd-Frank Act came into existence in the year 2010, after the Great financial crisis of 2008. It is officially known as Dodd-Frank Wall Street Reform and Consumer Protection Act. The Act was first proposed in 2009, was passed by President Barrack Obama and became law in 2010. The main motive of the Act was to put more stringent checks and controls on the financial services industry. It would help in preventing the exploitation of gullible customers at the hands of lenders and mortgage companies.
The Act focuses on sixteen major and critical areas for reforms. It aims to restrict/avoid the use of taxpayers’ money for a future bailout of a bank or financial institution.
Modus-operandi and critical provisions of the Dodd-Frank Act
The Act aims to ensure the cooperation of insiders engaged in financial and trading activities. Also, it seeks to keep a check on corruption in the industry. To achieve these goals, the Act incorporates a whistleblowing provision. It encourages people with information on security violations to report and inform the government. It ensures their safety, and they also get a financial reward for the disclosure.
Financial stability and security
To ensure financial stability, the Act created the Financial Stability Oversight Council (FSOC) and the Orderly Liquidation Authority. They keep a strict vigil on the financial stability of major financial firms, which are very big, and whose failure can damage the US economy seriously. The Volcker Rule also came into existence under which financial institutions can make investments with restrictions. They have to separate their investment and commercial functions. Also, they cannot invest or own a proprietary trading operation or a hedge fund for profit.
Banks should have a contingency plan in place in case their funds and reserves dry up. Also, the reserve limit has been raised, and banks and financial institutions are to adhere to the new restrictions. A “stress test” by the Federal Reserve has been made compulsory for banks having assets of US $50 billion or more. Thus, this test will help in determining the bank’s ability to survive a financial crisis.
The Dodd-Frank act has created the Consumer Financial Protection Bureau (CFPB) as an independent financial regulator to protect the interests of the consumers. It helps in preventing corrupt business practices of banks and financial institutions. It oversees consumer finance markets, student loans, credit cards, and other mortgages and supervises financial institutions to control risky lending. Also, it aims to ensure that terms of a lease are easy for customers to understand before they agree. The subprime mortgage crisis was the result of greedy lending, and the CFPB aims to check all activities that could lead to another such disaster.
The Act also set up an SEC Office of Credit Ratings.12 Credit rating agencies contributed to the financial crisis by giving false and favorable ratings. Moreover, such ratings misled the public into wrong investments. Hence this office came into existence. It ensures that rating agencies do their work honestly and diligently and give proper ratings to the entities.
Shortcomings of the Dodd-Frank Act
There was criticism of the Act because it can cripple the competitiveness of firms based in the US. Their competition from other countries can benefit from this situation. The stringent regulatory requirements can unnecessarily burden the small banks and financial institutions. In reality, these small institutions did not have any role in the financial crisis.
Also, too many regulations hamper innovation and new financial product launches. It would affect the liquidity in the market too. Besides, institutions have to hold higher reserves. It automatically decreases their purchasing power of marketable securities. Thus, banks find it hard to be market makers.
Changes in the Dodd-Frank Act
The US government was forced to bring reforms to the Dodd-Frank Act with growing criticism. It passed a bill called the Economic, Growth, Regulatory Relief, and Consumer Protection Act in 2018 to take back many portions of the Act. President Trump signed it to turn it into law on May 24, 2018. The changes are:
Small and midsize banks
Banks having assets between the US $100 billion- $250 billion will face lower scrutiny levels. Also, there will be no requirement for the stress test. Banks with assets less than the US $10 billion need not follow the Volcker rule. Therefore, they can undertake risky investments, too, with the money of the depositors. It increases the chances of earning handsome profits.
Large Banks with custody
Many institutions act as custodians of the client’s assets but do not undertake lending and other traditional banking activities. As per the new law, they need lesser capital to function as well as lower leverage ratios.
Residential mortgage loans held by a depository institution or a credit union are exempted from escrow requirements conditionally.
Consumers can now freeze their credit files with the three major credit reporting agencies without having to pay any extra charge. Thus, this would act as a fraud deterrent.