Dodd-Frank Wall Street Reform and Consumer Protection Act
The Dodd-Frank Wall Street Reform and Consumer Protection Act, commonly referred to as Dodd-Frank, is a significant piece of U.S. legislation enacted in 2010 in response to the financial crisis of 2007-2008. The act was designed to implement comprehensive reforms in the American financial sector to enhance oversight and protect consumers from risky banking practices. It established the Financial Stability Oversight Council (FSOC) to monitor systemic risks and ensure banks maintain sufficient cash reserves to prevent future economic crises. Key provisions of Dodd-Frank include restrictions on banks' investment practices and the formation of the Consumer Financial Protection Bureau (CFPB), which aims to safeguard consumers from potentially predatory financial practices. The legislation also increased federal regulation of credit-rating agencies and derivative trading, addressing issues that contributed to the previous financial collapse. While there have been calls for modifications to Dodd-Frank, many of its reforms have already been integrated into the operational framework of the financial industry. Overall, Dodd-Frank represents a significant effort to stabilize the financial system and protect consumers in the wake of a major economic downturn.
Dodd-Frank Wall Street Reform and Consumer Protection Act
The Dodd-Frank Wall Street Reform and Consumer Protection Act, also known simply as Dodd-Frank, is a piece of US legislation that made sweeping reforms to the American financial industry when President Barack Obama signed it into law in 2010. Dodd-Frank granted the US federal government the authority to regulate the American banking industry in the interest of protecting consumers from risky banking practices that gamble with investors' money.
Dodd-Frank was passed in the aftermath of the financial crisis of 2007 and 2008, a global financial meltdown caused by, among other activities, years of risky mortgage lending by US banks. These risks ultimately led to the collapse of the US housing market and widespread bankruptcy among banks. The collapse stagnated the US economy and quickly spread around the world. Dodd-Frank regulated US banks to prevent such a crisis from happening again.
Background
The 2007–2008 financial crisis started with risky mortgage lending by US banks that peaked in the mid-2000s. The US housing market was booming at that time, with prices at record levels. Housing prices began declining in 2006. This was known as the "busting" of the housing "bubble."
The bust had occurred due to what became known as the US subprime mortgage crisis. Subprime mortgages are home loans made by banks to individuals with low credit scores. Low scores mean the individuals have histories of defaulting on loan payments. To protect themselves from the risk of lending to these people, banks include higher-than-normal interest rates in subprime mortgages.
By the mid-2000s, the US housing supply had increased, while demand for housing had decreased. Consequently, housing prices fell. Inevitably, many Americans who had bought homes through subprime mortgages found they could not pay back their loans. Nor could they sell their homes, since demand remained low. Therefore, US banks did not receive the money they were owed, and they later foreclosed on many homes.
Meanwhile, the banks had sold these mortgages to other financial institutions as assets to back up securities, or financial objects that can be traded for investment. A multitude of banks and other financial-services companies around the world owned these securities, which were invested in mutual funds, pension funds, and corporate assets. The US housing market truly began to collapse in 2007, with millions of Americans defaulting on their subprime mortgages and losing their homes to foreclosure.
Banks that had issued the subprime mortgages suddenly had no hard cash to fulfill the obligations they had made to other institutions through their mortgage-backed securities. As a result, banks stopped trading with one another, and many eventually filed for bankruptcy, since their financial products were worthless. This caused a wave of panic across the US financial industry and around the world. US stock prices sharply decreased, and millions of Americans became unemployed as a result of the economic downturn.
In 2008, President George W. Bush authorized the US government to spend $700 billion to bail out failing US banks. In 2009, Obama ordered $787 billion to be injected into the US economy to renew growth. The period of global economic decline that lasted from late 2007 to mid-2009 became known informally as the Great Recession.
Overview
In the midst of the recession, Democratic US representative Barney Frank and Democratic US senator Chris Dodd worked with the Obama administration to create legislation that would overhaul the rules of the American financial sector. The legislation's ultimate goals were to place much of the US banking industry under federal oversight to prevent banks from engaging in reckless financial practices and protect the American people and economy from the potentially disastrous effects of another financial meltdown. The US Congress approved the Dodd-Frank Wall Street Reform and Consumer Protection Act in the summer of 2010. Obama signed it into law on July 21, 2010.
Dodd-Frank consisted of more than 2,300 pages detailing new regulations for the financial sector. The act first stipulated that a new federal agency called the Financial Stability Oversight Council (FSOC) would monitor the financial industry for risks that most greatly threatened the US economy.
The FSOC was to recommend that the Federal Reserve, the United States' central banking system, start monitoring any banks that were growing beyond certain levels. The Federal Reserve would ensure that these banks increased their minimum cash reserves so they could provide consumers with their money in case of another financial emergency. The Federal Reserve would also annually test each institution worth more than $50 billion to determine if it could withstand the shock of another financial collapse.
Meanwhile, the institutions' increased reserves meant that no such corporation would ever again become "too big to fail," which some corporate leaders had believed their enterprises to be in 2008. Too big to fail is a theory contending that some companies are so important and interwoven into an economy that the government must always rescue them from financial failure to prevent a wider economic catastrophe. Dodd-Frank permitted the federal government to break up banks found to be too big to fail.
Dodd-Frank also banned banks from using customers' money to invest in hedge funds for the banks' own gain. Hedge funds are risky investment portfolios that can yield profitable returns. The banks could invest in hedge funds only for their customers. The Securities and Exchange Commission (SEC) or the Commodity Futures Trading Commission (CFTC) were to oversee the trading of derivatives, or contracts that derive their value from underlying assets such as stocks or commodities. The federal government would stop the riskiest derivatives trading before it led to a crisis.
Another major aspect of Dodd-Frank was the law's requirement that the SEC oversee credit-rating agencies such as Standard & Poor's and Moody's. These entities were accused of overrating the values of mortgage-backed securities and derivatives before the 2008 crisis. The SEC can inspect and determine the accuracy of these agencies' ratings. Agencies found to have issued deceptive ratings can be banned from participating in the credit-ratings industry.
To protect the American people from banks' potentially predatory financial practices, Dodd-Frank created the Consumer Financial Protection Bureau (CFPB). The bureau monitors fees on loans, credit and debit cards, and bank transactions. It also requires that consumers comprehend the terms of risky mortgages before agreeing to them and that banks confirm borrowers' employment status, income, and credit history when authorizing loans.
In 2017, President Donald Trump claimed he wanted to change some bank regulations made by Dodd-Frank. Trump said the law discouraged banks from lending money and was stifling the US economy. However, according to financial news network CNBC, Dodd-Frank was unlikely ever to be fully repealed, as the American financial industry had already instituted many of the law's reforms.
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