What is the Dodd-Frank Wall Street Reform and Consumer Protection Act?

The Dodd-Frank Wall Street Reform and Consumer Protection Act is a massive piece of financial reform legislation passed during the Obama administration in 2010 as a response to the financial crisis of 2008. Named after sponsors Sen. Christopher J. Dodd (D-Conn.) and Rep. Barney Frank (D-Mass.), the act contains numerous provisions, spelled out over roughly 2,300 pages, that were to be implemented over a period of several years.

Dodd-Frank established a number of new government agencies tasked with overseeing the various components of the act and, by extension, various aspects of the financial system. President Donald Trump pledged to repeal Dodd-Frank and, in May 2018, signed a new law rolling back significant portions of it.

Key Takeaways

  • The Dodd-Frank Wall Street Reform and Consumer Protection Act targeted the sectors of the financial system that were believed to have caused the 2008 financial crisis, including banks, mortgage lenders, and credit rating agencies.
  • Critics of the law argue that the regulatory burdens it imposes could make United States firms less competitive than their foreign counterparts.
  • In 2018, Congress passed a new law that rolled back some of Dodd-Frank's restrictions.

How the Dodd-Frank Wall Street Reform and Consumer Protection Act Works

The Dodd-Frank Wall Street Reform and Consumer Protection Act has many components. These are some of its key provisions and how they work:

Financial stability

Under Dodd-Frank, the Financial Stability Oversight Council and Orderly Liquidation Authority monitor the financial stability of major financial firms whose failure could have a serious negative impact on the U.S. economy (companies deemed "too big to fail"). The law also provides for liquidations or restructurings via the Orderly Liquidation Fund, established to assist with the dismantling of financial companies that have been placed in receivership and prevent tax dollars from being used to prop up such firms.

The council has the authority to break up banks that are considered so large as to pose a systemic risk; it can also force them to increase their reserve requirements. Similarly, the new Federal Insurance Office was tasked with identifying and monitoring insurance companies considered "too big to fail."

Consumer Financial Protection Bureau

The Consumer Financial Protection Bureau (CFPB), established under Dodd-Frank, was given the job of preventing predatory mortgage lending (reflecting the widespread sentiment that the subprime mortgage market was the underlying cause of the 2008 catastrophe) and make it easier for consumers to understand the terms of a mortgage before agreeing to them. It deters mortgage brokers from earning higher commissions for closing loans with higher fees and/or higher interest rates and requires that mortgage originators not steer potential borrowers to the loan that will result in the highest payment for the originator.

The Dodd-Frank Wall Street Reform and Consumer Protection Act was intended to prevent another financial crisis like the one in 2008.

The CFPB also governs other types of consumer lending, including credit and debit cards, and addresses consumer complaints. It requires lenders, excluding automobile lenders, to disclose information in a form that is easy for consumers to read and understand; an example is the simplified terms now on credit card applications.

The Volcker Rule

Another key component of Dodd-Frank, the Volcker Rule, restricts the ways banks can invest, limiting speculative trading and eliminating proprietary trading. Banks are not allowed to be involved with hedge funds or private equity firms, which 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." The Volcker Rule is clearly a push back in the direction of the Glass-Steagall Act of 1933, which first recognized the inherent dangers of financial entities extending commercial and investment banking services at the same time.

The act also contains a provision for regulating derivatives, such as the credit default swaps that were widely blamed for contributing to the 2008 financial crisis. Dodd-Frank set up centralized exchanges for swaps trading to reduce the possibility of counterparty default and also required greater disclosure of swaps trading information to increase transparency in those markets. The Volcker Rule also regulates financial firms' use of derivatives in an attempt to prevent "too big to fail" institutions from taking large risks that might wreak havoc on the broader economy.

SEC Office of Credit Ratings

Because credit rating agencies were accused of contributing to the financial crisis by giving out misleadingly favorable investment ratings, Dodd-Frank established the SEC Office of Credit Ratings. The office is charged with ensuring that agencies provide meaningful and reliable credit ratings of the businesses, municipalities and other entities they evaluate.

Whistleblower program

Dodd-Frank also strengthened and expanded the existing whistleblower program promulgated by the Sarbanes-Oxley Act (SOX). Specifically, it established a mandatory bounty program under which whistleblowers can receive from 10% to 30% of the proceeds from a litigation settlement, broadened the scope of a covered employee by including employees of a company's subsidiaries and affiliates, and extended the statute of limitations under which whistleblowers can bring forward a claim against their employer from 90 to 180 days after a violation is discovered.

Criticisms of the Dodd-Frank Wall Street Reform and Consumer Protection Act

Proponents of Dodd-Frank believed the act would prevent the economy from experiencing a crisis like that of 2008 and protect consumers from many of the abuses that contributed to the crisis. Detractors, however, have argued that the act could harm the competitiveness of U.S. firms relative to their foreign counterparts. In particular, they contend that its regulatory compliance requirements unduly burden community banks and smaller financial institutions—despite the fact that they played no role in causing the financial crisis.

Such financial-world notables as former Treasury Secretary Larry Summers, Blackstone Group L.P. (BX) CEO Stephen Schwarzman, activist Carl Icahn, and JPMorgan Chase & Co. (JPM) CEO Jamie Dimon also argue that, while each institution is undoubtedly safer due to the capital constraints imposed by Dodd-Frank, the constraints also make for a more illiquid market overall. The lack of liquidity can be especially potent in the bond market, where all securities are not mark to market and many bonds lack a constant supply of buyers and sellers.

The higher reserve requirements under Dodd-Frank mean banks must keep a higher percentage of their assets in cash, which decreases the amount they are able to hold in marketable securities. In effect, this limits the bond market-making role that banks have traditionally undertaken. With banks unable to play the part of a market maker, prospective buyers are likely to have a harder time finding counteracting sellers. More importantly, prospective sellers may find it more difficult to find counteracting buyers.

Changes to the Dodd-Frank Wall Street Reform and Consumer Protection Act

Siding with the critics, the U.S. Congress passed a bill in 2018 called the Economic Growth, Regulatory Relief and Consumer Protection Act, which rolls back significant portions of the Dodd-Frank Act. It was signed into law by President Trump on May 24, 2018. These are some of the provisions of the new law, and some of the areas in which standards were loosened:

Small and regional banks

The new law eases the Dodd-Frank regulations for small and regional banks by increasing the asset threshold for the application of prudential standards, stress test requirements, and mandatory risk committees.

Large custodial banks

For institutions that have custody of clients' assets but do not function as lenders or traditional bankers, the new law provides for lower capital requirements and leverage ratios.

Mortgage credit

The new law exempts escrow requirements for residential mortgage loans held by a depository institution or credit union under certain conditions. It also directs the Federal Housing Finance Agency to set up standards for Freddie Mac and Fannie Mae to consider alternate credit scoring methods

Small lenders

The law exempts lenders with assets of less than $10 billion from requirements of the Volcker rule and imposes less stringent reporting and capital norms on small lenders.

Credit bureaus

The law requires that the three major credit reporting agencies allow consumers to "freeze" their credit files free of charge as a way of deterring fraud.