Repeal of Dodd Frank Act-Heralding a new financial crisis?

By Nicolas Deising* & Nihal Dsouza**

The Dodd Frank Act is considered to be the most ambitious and far reaching legislation regulating the financial sector since the Great Depression of the 1930’s. On the surface, it instills confidence in the financial system. At a deeper level, it is aimed at preventing similar occurrences to the 2008 financial crisis, in which millions of people lost their homes and jobs and trillions of dollars of national wealth disappeared. Despite its benefits, the Act has been criticized for being overly complex and not achieving its stated goals. Most recently moves, both through an executive order and legislative action in the Senate, have been made to reduce the Act’s efficacy and subsequently clear the path for its repeal. These decisions of the new Administration are in line with their policy of minimum governmental regulation.

These measures, however, may prove to be short-sighted as they underestimate the importance of the legislation. The Dodd Frank Act has made the financial system more secure by providing significant tools to ensure stability and consumer protection. It ensured that systematically important banks did not indulge in inherently risky activities such as proprietary trading. By doing so, systemic risk is precluded wherein failing big banks would not be able to pull down smaller ones.

In order to prevent the occurrence of a new crisis, Dodd Frank introduced a new regulatory regime with strict obligations and prohibitions for financial institutions on the one hand and a plethora of provisions for consumer protection on the other. Dodd Frank puts in place a regulatory framework to reduce risks to the financial markets. The Act has numerous sections ensuring that the responsible authorities have the necessary discretionary powers for effective implementation and enforcement. The Securities Exchange Commission (SEC), the Commodities Futures Trading Commission (CFTC), the Board of Governors of the Federal Reserve System and finally the Consumer Financial Protection Bureau (CFPB) are essentially responsible for ensuring implementation of the Act.

The CFPB, established by Dodd Frank serves the vital function of preventing predatory mortgage lending, which was one of the major factors that led to a bubble on the housing markets. Thus, it acts as an independent financial regulator. Furthermore, the Act also created an interagency group, the Financial Stability Oversight Council (FSOC), which is endowed with the authority for monitoring risks to the financial system. Its purpose is identifying risks and responding to them and promoting market discipline. The FSOC consists of representatives from federal and state regulators as well as independent insurance experts. A central component of the Act is the “Volcker Rule” in Title VI, which prohibits speculative activities for commercial banks. In particular, the Volcker Rule doesn’t allow banks to invest in hedge funds or private equity firms. The Act in Title VII also addresses the reduction of risks inherent to derivatives trading. Over-the-counter (OTC) credit derivatives spread and increased the risks posed by asset-backed securities (ABS) and collateralized debt obligations (CDO) during the crisis. Therefore, the Act mandates higher transparency standards and liquidity requirements for financial institutions. To decrease systemic risk, the Act also requires clearing over a central counterparty that sits between the buyer and the seller and guarantees the performance of contracts. Additionally, Dodd Frank mandates exchange trading for several swaps. Exchange trading, in contrast to over-the-counter trading is standardized, transparent, and regulated and consequently safer. Furthermore, the Act imposes higher capital requirements on financial institutions and thereby decreases their leverage. The council has to make recommendations to the Federal Reserve to establish standards for risk based capital, leverage, liquidity, and contingent capital. Another major achievement of the Act is the regulation of credit rating agencies like Moody´s and Standard and Poor’s by creating an Office of Credit Ratings at the SEC.

The Dodd Frank Act has been the subject of numerous criticisms. It has been argued that the Act increases the compliance costs for financial institutions without giving any substantial benefits to the public. Critics also argue that the Act unduly burdens small banks by subjecting them to the same rigorous standards as larger banks, and that this is bad for the economy. Moreover, some scholars have raised arguments against the consumer protection provisions, on grounds that the added cost and complexity makes it more profitable for creditors to concentrate their lending only on well-to-do borrowers, thereby making it harder for middle-class borrowers to access credit. Furthermore, it is contended that increased regulation is inherently bad for consumers because banks would ultimately pass on the added cost of implementation to them. There are also worries that the Act is overly complex, and that too much regulation itself affects financial stability. In addition, it is argued that excessive regulation and the absence of a level playing field puts U.S. institutions in more difficult position then their European counterparts, leading to regulatory arbitrage.

Most of these criticisms can be addressed and do not justify an outright repeal of the Act. The threat of regulatory arbitrage, for instance, is greatly reduced by the uniformity in the approach taken by the G20, and in any case with the Basel III standards implemented and transposed universally there will be little chance of regulatory arbitrage. Furthermore, it is better for consumers to pay a little more for financial services rather than face the prospect of another banking crisis. It is also important not to forget that the Act provides legislation in important areas that were hitherto unregulated; for instance, it regulates shadow banks and the non-bank financial institutions (NBFI), which were previously contributors to the crisis. It prevents predatory lending and the so-called Ninja Mortgages. Although there is merit in some of the criticisms notably regarding the negative impact on smaller or community banks, the safer way forward, which would be acceptable to both sides of the political spectrum, would be to amend the Act and not try for an outright repeal. A possible solution would be to reduce the burden on smaller banks by ensuring that the strictest requirements are only for the systemically important financial institutions (SIFIs) and not the smaller institutions.

With the passing of almost a decade since the financial crisis, it appears as if lawmakers have gotten lax and forgotten the catastrophic effects which came in its wake and the lack of regulation which led to it, which made some of the most significant financial institutions collapse. Dodd Frank was intended to ensure that SIFI’s would not fail, and this goal remains as relevant today as it was pre-financial crisis. The Act contributes enormously to the progress made in recent years in ensuring a more resilient banking system that can limit the outfall of any potential future crisis. Its repeal would make many bankers happy but would in effect ‘pull the rug out from under’ the global financial system.

* Nicolas Deising is a Research Assistant at the University of Bonn and a PhD Student.

** Nihal Dsouza is a Research Assistant at the University of Bonn and a PhD Student at the International Max Planck Research School for Successful Dispute Resolution (IMPRS-SDR).

Photo Credit: Nakashi

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