What Is the Dodd-Frank Wall Street Reform and Consumer Protection Act?
The Dodd-Frank Wall Street Reform and Consumer Protection Act is legislation that was passed by the U.S. Congress in response to financial industry behavior that led to the financial crisis of 2007–2008. It sought to make the U.S. financial system safer for consumers and taxpayers.
Named for sponsors Sen. Christopher J. Dodd (D-Conn.) and Rep. Barney Frank (D-Mass.), the act contains numerous provisions, spelled out over 848 pages, that were to be implemented over a period of several years.
- The Dodd-Frank Act targeted financial system sectors that were believed to have caused the 2007–2008 financial crisis.
- Leading up to 2007, lax regulations led to extremely risky lending practices, which caused a housing sector bubble that ultimately burst and drove the global crisis, the need for public bailouts of financial institutions, and the recession.
- The institutions considered responsible for the 2007–2008 financial crisis included banks, insurance companies, investment banking firms, mortgage lenders, and credit rating agencies.
- Critics of the law argue that the regulatory burdens it imposes could make U.S. firms less competitive than their foreign counterparts.
- In 2018, Congress passed a new law that rolled back some of Dodd-Frank’s restrictions.
Understanding the Dodd-Frank Act
The Dodd-Frank Wall Street Reform and Consumer Protection Act is a massive piece of financial reform legislation that was passed in 2010, during the Obama administration.
Commonly known as the Dodd-Frank Act, or Dodd-Frank, it established a number of new government agencies tasked with overseeing the various components of the law and, by extension, various aspects of the financial system.
The 2007–2008 financial crisis is perhaps the worst economic catastrophe to befall the country (and the world) since the Wall Street crash in 1929. Broadly speaking, it was caused by greed-driven behavior and lax oversight of financial institutions.
The loosening of financial industry regulations in the decades leading up to 2007 allowed various types of institutions in the U.S. financial services industry to lend money in ways that were riskier than ever before. The housing sector in particular experienced massive growth that couldn't be supported.
The bubble burst, sending the banking industry and global stock markets into a downfall. It created the worst global recession in generations.
Dodd-Frank was created to keep anything similar from ever happening again.
The Dodd-Frank Wall Street Reform and Consumer Protection Act was intended to prevent another financial crisis like the one in 2007–2008.
Components of the Dodd-Frank Act
Here are some of the law’s key provisions and how they work:
- Financial Stability: Under the Dodd-Frank Act, the Financial Stability Oversight Council and the Orderly Liquidation Authority monitor the financial stability of major financial firms. The failure of these companies (deemed too big to fail) could have a serious negative impact on the U.S. economy. The law also provides for liquidations or restructurings via the Orderly Liquidation Fund. This fund was established to assist with the dismantling of financial companies that have been placed in receivership to 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 systemic risk. It can also force banks to increase their reserve requirements. Similarly, the new Federal Insurance Office was tasked with identifying and monitoring insurance companies that also felt to be 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 and helping consumers to understand the terms of a mortgage before agreeing to it. This reflected the widespread sentiment that the subprime mortgage market was the underlying cause of the 2007–2008 catastrophe. The CFPB deters mortgage brokers from earning higher commissions for closing loans with higher fees and/or higher interest rates. It requires that mortgage originators not steer potential borrowers to the loan that will result in the highest payment for the originator. 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. Such an example is the simplified terms now on credit card applications.
- Volcker Rule: The Volcker Rule restricts how banks can invest, limits speculative trading, and eliminates proprietary trading. Banks are not allowed to be involved with hedge funds or private equity firms, which are considered too risky. To minimize possible conflicts of interest, financial firms are not allowed to trade proprietarily without sufficient "skin in the game.” The Volcker Rule is clearly a pushback 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 2007–2008 financial crisis. Dodd-Frank set up centralized exchanges for swaps trading to reduce the possibility of counterparty default. It 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.
- Securities and Exchange Commission (SEC) Office of Credit Ratings: Dodd-Frank established the SEC Office of Credit Ratings because credit rating agencies had been accused of giving out misleading favorable investment ratings in the lead-up to the financial crisis. The office is charged with ensuring that agencies provide meaningful and reliable credit ratings of the businesses, municipalities, and other entities that they evaluate.
- Whistleblower Program: Dodd-Frank also strengthened and expanded the existing whistleblower program promulgated by the Sarbanes-Oxley Act (SOX) of 2002. 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.
The Economic Growth, Regulatory Relief, and Consumer Protection Act
When Donald Trump was elected president in 2016, he pledged to repeal Dodd-Frank. Siding with critics, the U.S. Congress passed the Economic Growth, Regulatory Relief, and Consumer Protection Act, which rolled back significant portions of the Dodd-Frank Act.
It was signed into law by then-President Trump on May 24, 2018.
These are some of the provisions of that law, and some of the areas in which previous standards were loosened:
- The new law eased 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.
- For institutions that have custody of clients’ assets but do not function as lenders or traditional bankers, the new law provided for lower capital requirements and leverage ratios.
- The new law exempted escrow requirements for residential mortgage loans held by a depository institution or credit union under certain conditions. It also directed the Federal Housing Finance Agency (FHFA) to set up standards for Freddie Mac and Fannie Mae to consider alternative credit scoring methods.
- The law exempted lenders with assets of less than $10 billion from requirements of the Volcker Rule and imposed less stringent reporting and capital norms on small lenders.
- The law required that the three major credit reporting agencies allow consumers to freeze their credit files free of charge as a way of deterring fraud.
After Joseph Biden was elected president in 2020, the CFPB focused on rescinding rules from the Trump era that were in direct conflict with the charter of the CFPB.
In June 2021, President Biden, along with the U.S. Department of Education and support from the CFPB, announced plans to cancel more than $500 million of student loan debt, which remains the subject of ongoing litigation. The CFPB has strengthened its oversight of for-profit colleges to tamp down on predatory student loan practices.
The Biden administration has also announced its intent to reestablish rules against other forms of predatory lending, such as payday loans. Additionally, subprime auto loan practices will be addressed by the CFPB.
Criticism of the Dodd-Frank Act
Proponents of Dodd-Frank believed that the law would prevent the economy from experiencing a crisis like that of 2007–2008 and protect consumers from many of the abuses that contributed to the crisis.
Detractors, however, have argued that the law 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 make for a more illiquid market overall.
The lack of liquidity can be especially potent in the bond market, where all securities are not marked to market and many bonds lack a constant supply of buyers and sellers. The higher reserve requirements under Dodd-Frank mean that banks must keep a higher percentage of their assets in cash. This decreases the amount that 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.
What Is the Purpose of the Dodd-Frank Act?
Dodd-Frank is intended to curb the extremely risky financial industry activities that led to the financial crisis of 2007–2008. Its goal was, and still is, to protect consumers and taxpayers from egregious practices like predatory lending.
Is the Dodd-Frank Act Still in Effect?
Yes, it is; however, its regulatory strength was diluted with the passage of the Economic Growth, Regulatory Relief, and Consumer Protection Act in 2018. Still, certain aspects, such as the bank stress tests it called for, are in use today. The Federal Reserve publishes stress test results regularly.
What Are Some Criticisms of the Dodd-Frank Act?
Detractors of the Dodd-Frank Act have argued that the law could harm the competitiveness of U.S. firms relative to their foreign counterparts. In particular, critics 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. Several financial world notables have also argued 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.
Could the Dodd-Frank Act Affect the Bond Market?
The potential lack of liquidity due to the higher reserve requirements under Dodd-Frank means that banks must keep a higher percentage of their assets in cash. This decreases the amount that 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 market makers, 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.
What Was the Impact of the 2018 Rollback of Dodd-Frank Regulations?
In 2018, the passage of the Economic Growth, Regulatory Relief, and Consumer Protection Act rolled back numerous regulations put in place by the Dodd-Frank Act. Under the Dodd-Frank rules, banks with $50 billion in assets were subject to more strenuous capital and liquidity requirements, but the new law in 2018 increased the asset threshold to $250 billion. This change relaxed the regulations for smaller and medium-sized banks. When Silicon Valley Bank collapsed in March 2023, observers argued that the lack of regulatory scrutiny on financial institutions of this size played a key role in the bank's failure.
The Bottom Line
The Dodd-Frank Act, enacted in 2010, was a direct response to the financial crisis of 2007–2008 and the ensuing government bailouts under the Troubled Asset Relief Program (TARP).
This law established a wide range of reforms throughout the entire financial system, with the purpose of preventing a repeat of the 2007–2008 crisis and the need for further government bailouts. The Dodd-Frank Act also included additional protections for consumers.
Although the Trump administration reversed and weakened several aspects of the Dodd-Frank Act, particularly those affecting consumers, the Biden administration intends to reestablish and strengthen the previous reversals to protect individuals who may be subject to predatory lending practices in industries like for-profit education and automobiles.