Loopholes In The Dodd-Frank Act

By James Kerin | September 25, 2012 AAA

The Dodd-Frank Wall Street Reform and Consumer Protection Act is a law enacted in direct response to the 2008 financial crisis. The bill is named after its sponsors, Representative Barney Frank and Senator Christopher Dodd. Following its approval in Congress, President Barack Obama signed the Act into effect on July 21, 2010. When first proposed, the bill was 848 pages long. However, the rules and regulations demanded by the law now fill 8,843 pages and continue to grow every day.

The Dodd-Frank Act is an enormously complicated piece of legislation that regulators, businessmen and politicians alike struggle to understand. In essence, the purpose of the Act is to establish preventive measures to ensure maximum consumer protection. This is accomplished by the imposition of a series of reforms in the financial services industry, as well as the establishment of oversight committees.

Oversight

Dodd-Frank created numerous government and regulatory agencies, including the Consumer Financial Protection Bureau, SEC Office of Credit Ratings, the Financial Stability Oversight Council and the Federal Insurance Office. These agencies are tasked with specific regulatory roles within the banking system. For example, the Consumer Financial Protection Bureau is assigned the enforcing of rules and regulations for large banks and credit unions. Each of these federal government agencies monitors various aspects of the banking system.

Financial Reform

In addition, the Dodd-Frank Act immediately brought into being a plethora of financial regulatory tightening. At the forefront of the reform was the increased "transparency and accountability for exotic instruments," such as asset-backed securities, derivatives and hedge funds. A solution to the age of "too big to fail" was also drawn up: capital and leverage requirements were raised and liquidation procedures for overly large companies were formed. Furthermore, regulators were bestowed with the authority to aggressively hunt down cases of fraud within the industry.

One of the most frequently cited articles of the Dodd-Frank Act is the Volcker Rule. Effectively separating the investment and commercial functions of a bank, the Volcker Rule highly limits the ability of banks to employ risk-on trading techniques and strategies when also servicing clients as a depository institution. Banks are not allowed to be involved with hedge funds or private equity firms, as these kinds of businesses are considered too risky. In an effort to minimize possible conflict of interests, financial firms are not allowed to trade proprietarily without sufficient "skin in the game."

While consumers and politicians are content, for the most part, with the Dodd-Frank Act, Wall Street leaders are skeptical about the necessity of the Volcker Rule and some of the capital and investment vehicle restrictions. Unfortunately, limiting the risks that a financial firm is able to take simultaneously decreases its profit-making ability. Aside from a few exceptions, the Volcker Rule is clearly a push back in the direction of the Glass-Steagall Act of 1933 - a law that first recognized the inherent dangers of financial entities extending commercial and investment banking services at the same time.

Loopholes in the Act

A major flaw of the Dodd-Frank Wall Street Reform and Consumer Protection Act is that its very length acts as a hindrance to the goals that the Act seeks to fulfill. The Glass-Steagall Act, one of the most influential and successful financial regulatory laws in the history of the United States, consisted of a mere 37 pages. The scores of regulators and government officials that continue to concoct additional rules and regulations to the original act merely invite banks to seek out technical loopholes in their rhetoric. There will always be contingencies that regulators cannot and will not be prepared for.

The Dodd-Frank Act also provides a glaring loophole for banks that claim to be "hedging" their bets. In theory, a hedge is a market position that consequently lowers the inherent risks of an underlying position. So long as a bank is operating in this manner, it can engage in proprietary trading with riskier groups of assets. However, JPMorgan's recent $5.6 billion gaffe has caused government officials to question the utility of the hedging exception.

The Bottom Line
The Dodd-Frank Wall Street Reform and Consumer Protection Act is a critically important piece of legislation that strengthens America's financial system and protects consumers. However, certain aspects of Dodd-Frank (whenever it reaches completion) should be re-examined for their efficacy.

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