What is Dodd-Frank Act?

What Is the Dodd-Frank Act?

The Dodd-Frank Wall Street Reform and Consumer Protection Act, commonly known as the Dodd-Frank Act or Dodd-Frank, was passed in 2010, just after the financial crisis of 2008, in order to prevent future economic collapses. In this post, we cover its purpose, provisions, and criticisms. 

What Was the Purpose of the Dodd-Frank Act?

The stated aims of the legislation are the following:

- To promote the financial stability of the United States

- To improve accountability and transparency

- To end “too big to fail”

- To protect the American taxpayer by ending bailouts

- To protect consumers from abusive financial service practices

Why Was the Dodd-Frank Act Passed?

Even though there were clear signs of stress, such as the crisis in the housing market, the actual escalation was when Lehman Brothers filed for bankruptcy in September 2008. Furthermore, this was followed by the failure or bailout of several institutions. 

The collapse of the mortgage and housing markets laid bare that there were critical systemic vulnerabilities, which exposed the banks to risky loans and securities. The persistence of these issues has resulted in the introduction of proposals for broad financial regulatory reforms, which often aimed to increase industry transparency and protect consumers from financial harm. 

Key Provisions of the Dodd-Frank Act

1. Consumer Financial Protection Bureau (CFPB) Creation: The Dodd-Frank Act led to the establishment of the CFPB, which aimed to prevent predatory mortgage lending and to help consumers understand the terms of a mortgage before accepting. 

2. Volcker Rule: This rule put restrictions on banks’ investments, speculative trading, and proprietary trading. It also imposed limits on the involvement of banks with hedge funds or private equity firms because of their high risk. 

3. FSOC and OFR Oversight: The Dodd-Frank Act also established the Financial Stability Oversight Council (FSOC) and the Office of Financial Research (OFR). While the aim of the FSOC was to identify risks to the U.S. financial system and to coordinate regulatory responses, the goal of establishing the OFR was to support the FSOC with data collection, research, and monitoring. 

4. Creation of the OLA: Since there were many organizations that needed bailouts during the crisis, the Act created the Orderly Liquidation Authority (OLA) to protect the system from failures of large financial institutions without resorting to taxpayer bailouts. 

5. Derivatives Regulation: The Act additionally imposed new rules for derivatives and swaps in order to increase oversight, transparency, and reduce counterparty risk. It required credit-default swaps and other transactions to be cleared through exchanges or clearinghouses. 

6. Whistleblower Program: Another important change that was introduced by the Dodd-Frank Act is the whistleblower program. The Act further strengthened and expanded the existing program that was passed with the Sarbanes-Oxley Act in 2002. It raised the percentage that whistleblowers can receive from litigation settlements from 10% to 30%, expanded the definition of a covered employee, and extended the time limit in which whistleblowers can bring forward a claim against their employer from 90 up to 180 days. 

How Has the Dodd-Frank Act Impacted the Financial Industry?

According to the Associated Press, the Act had a profound effect on smaller financial institutions. Due to the rising compliance costs, they decided to eliminate several services such as free checking accounts, certain mortgage products, and auto loans. 

Moreover, according to a Harvard University study, community banks saw a steep decline in their share of U.S. banking assets and lending from over 40% to 20%. The study also shows that the regulations most heavily affected the smaller banks. However, there are still contradictory views on this subject. 

The CFPB’s “Enforcement by the Numbers” page also shows that since 2011, the Act directly or indirectly resulted in $19.7 billion in customer relief and approximately 195 million eligible consumer accounts. 

Criticism for Dodd-Frank Act

· Too strict for small banks: One of the major reasons for criticism was centered around the fact that it could do more harm to the competitiveness of U.S. firms, especially the smaller financial institutions, compared to foreign ones. Detractors also find that these requirements are very burdensome for these small institutions even though they had no part in the financial crisis.  

· It didn’t fix “Too Big to Fail”: Since one of the principal goals of the Act was to end the “too big to fail” dynamic, failure to do so resulted in several denunciations. According to Centre for Economic Policy Research (CEPR), it does not mitigate the mispricing of government guarantees in the financial sector and the broader costs remain externalized to the public. Thus, the true systemic risk ultimately persists. 

· Barrier to innovation: Fintechs and community banks face complex and slow approval processes, in addition to the increased compliance costs. Furthermore, the Act has triggered years of uncertainty because it was not clear how rules would be implemented, which led to several disadvantages such as institutions shifting abroad. Thus, it is possible to say that the attempt to reinforce stability resulted in a less innovative financial landscape in the U.S.

Rollbacks

· 2018 Reform: On May 24, 2018, President Donald Trump signed “Economic Growth, Regulatory Relief, and Consumer Protection Act”, which is considered as the most significant rollback on the Dodd-Frank Act. It raised the threshold for enhanced Federal Reserve supervision from $50 billion to $250 billion, eased stress-testing frequency for mid-sized banks and loosened mortgage and reporting rules for community banks and credit unions.

· Regulatory Reinterpretations and Agency Actions (2017-2020): Regulators such as the Federal Reserve, FDIC, and SEC relaxed multiple Dodd-Frank provisions, which included easing the Volcker Rule to allow banks to have more proprietary trading flexibility in 2019 and reduced liquidity coverage for smaller firms. 

· Debates on Rollbacks: The collapse of Silicon Valley Bank in 2023 led to several criticisms of rollbacks that reduced oversight requirements for midsized banks. Therefore, there are discussions on possible reinstatement of stricter liquidity and stress-testing rules. 

Dodd-Frank and Global Compliance Trends

A Global Benchmark: The Act led to many reforms in several jurisdictions worldwide such as MiFID (Market in Financial Instruments Directive) and EMIR (European Market Infrastructure Regulation) in the EU, the Banking Reform Act in the UK, and Basel III. It can be considered a wake-up call in derivatives transparency, capital requirements, and systemic risk oversight. 

Extraterritorial Reach: The Dodd-Frank Act particularly forced foreign banks in the U.S. to comply with U.S. reporting, stress-testing, and resolution-planning rules. At the same time, due to the rising compliance costs, as we have mentioned in the previous sections, has led some foreign institutions to relocate outside the U.S.

International Coordination: The G20 nations agreed on a coordinated global response just after the 2008 financial crisis. The Dodd-Frank Act not only inspired other financial reforms but its rules also often align with Basel III standards. Furthermore, U.S. agencies started to collaborate more closely and actively shared data with other financial authorities. All of this led to greater global regulatory cooperation.