How did the financial crisis affect the banking sector?

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May 2018

Over the short term, the financial crisis affected the banking sector by causing banks to lose money on mortgage defaults, interbank lending to freeze and credit to consumers and businesses to dry up. For the much longer term, the financial crisis impacted banking by spawning new regulatory actions internationally through Basel III and in the United States through the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Subprime Mortgages

Before the financial crisis hit in 2008, regulations passed in the U.S. had pressured the banking industry to allow more consumers to buy homes. Starting in 2004, Fannie Mae and Freddie Mac purchased huge numbers of mortgage assets including risky Alt-A mortgages. They charged large fees and received high margins from these subprime mortgages, also using the mortgages as collateral for obtaining private-label mortgage-backed securities.

Many foreign banks bought collateralized U.S. debt as subprime mortgage loans were rebundled into collateralized debt obligations and sold to financial institutions around the world. When increasing numbers of U.S. consumers defaulted on their mortgage loans, U.S. banks lost money on the loans, and so did banks in other countries. Banks stopped lending to each other, and it became tougher for consumers and businesses to get credit.

With the U.S. falling into a recession, the demand for imported goods plummeted, helping to spur a global recession. Confidence in the economy took a nosedive and so did share prices on stock exchanges worldwide.

Basel III

In hopes of averting another financial crisis, in December of 2009, the international Basel Committee introduced a set of proposals for new capital and liquidity standards for the global banking sector. The reforms, known as Basel III, were passed by the G-20 in November 2010, but the committee left it to member nations to implement the standards in their own countries.

Dodd-Frank Act

In the U.S., the Dodd-Frank Act, passed in 2010, requires bank holding companies with more than $50 million in assets to abide by stringent capital and liquidity standards and it sets new restrictions on incentive compensation.

The legislation also created the Financial Stability Oversight Council, to include the Federal Reserve Bank and other agencies for the purpose of coordinating the regulation of larger, "systemically important" banks. The council can break up large banks that might present risk because of their sizes. A new Orderly Liquidation Fund was established to provide financial assistance for the liquidation of big financial institutions that fall into trouble.

Some critics charge, however, that the act passed by U.S. Congress in 2010 is a greatly weakened version of the bill originally envisioned by President Barack Obama, watered down during its development through legislative and lobbyist maneuvering.

Crapo Bill

When President Donald Trump took office he ordered a review of the Dodd-Frank Act, with the aim of eliminating many of its rules. In March of 2018 the Economic Growth, Regulatory Relief, and Consumer Protection Act  (S.2115), also known as the Crapo Bill, passed the Senate. The bill is named after Mike Crapo, a United States Senator (R-ID) and chairman of the Senate Banking Committee, who sponsored it. It is designed to roll back parts of Dodd–Frank.

If passed into law, one of the main provisions of the Crapo Bill would increase the asset threshold that banks must pass to $250 billion, up from $50 billion under Dodd-Frank. The Crapo Bill must be reconciled with the Financial CHOICE Act in order to pass into law.

SEC Rules

The Dodd-Frank Act also contains more than 90 provisions that require rule-making by the U.S. Securities and Exchange Commission (SEC), along with dozens of other provisions where the SEC has been given discretionary rule-making authority. As of May 2018, the SEC was still working its way through adopting or proposing rules for all of the mandatory rule-making provisions.

Rules that have been adopted so far include bringing more transparency to the swap fund and hedge fund markets, giving investors say over executive compensation and setting up a whistle-blowers program for securities law violations, for instance.

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