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In the years that followed passage of the Dodd-Frank Act, the U.S. fully recovered from the economic crisis that inspired its creation and enjoyed the longest bull market in history.
The financial crisis of 2007-2008 was one of the worst economic disasters in modern U.S. history, and it was in large part caused by bad behavior at banks. The Dodd-Frank Act was created in an attempt to keep anything similar from happening again.
Here’s what you need to know about the events that led to the creation of this important financial act and how it’s changed over the years.
Deregulation and the 2008 Financial Crisis
In the 25 years leading up to the financial crisis of 2007-2008, financial industry deregulation permitted—some might even say encouraged—U.S. financial services firms to take bigger and bigger gambles, and lend in riskier ways than ever before.
The result was an epic bubble in the U.S. housing sector that wrecked the banking industry and crashed stock markets at home and abroad, driving the worst global recession seen in generations.
Passed by Congress and signed into law by President Barack Obama in July 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act sought to restore stability and oversight to the financial system and prevent a repeat of the crisis.
How Does Dodd-Frank Regulate the Financial Industry?
The Dodd-Frank Act was written by (and named for) Senator Chris Dodd and Representative Barney Frank. All in all, the Dodd-Frank Act is an extraordinarily complicated regulation that covers a wide spectrum of financial industry activities.
These are the key provisions of Dodd-Frank that impose rules and establish regulatory bodies to watch over the financial services industry and protect consumers.
1. The Financial Stability Oversight Council (FSOC)
The Financial Stability Oversight Council(FSOC)is responsible for keeping banks and other financial firms from becoming “too big to fail.” One of the drivers of the 2008 crisis was that a few financial firms had become so large and so important to the functioning of the financial system that the U.S. government was forced to save them from their own bad decisions.
Dodd-Frank gave the FSOC powerful tools to prevent any individual firm from becoming this large or important to the economy. The council, made up of Treasury Department and Federal Reserve officials, advised by industry experts and academics, is changed with identifying risks to financial stability. But perhaps its greatest power is the ability to impose strict regulations on and even break up firms that pose major risks to the economy.
2. Banking Industry Stress Tests
Dodd-Frank mandated that the Federal Reserve more closely monitor the largest banks and financial institutions in the U.S., including giant insurance companies. The act required special annual tests to ensure these very large institutions were prepared for the inevitable arrival of recessionsand future financial crises.
These so-called stress tests use hypothetical scenarios to assess the impact different financial shocks might have on their stability. If a bank doesn’t have enough capital on hand under certain scenarios, the Fed can suspend share buybacks or put a cap on dividends to ensure the bank remains strong enough to lend to struggling businesses and survive hard economic times.
3. The Consumer Financial Protection Bureau
Of all the new regulatory bodies created by Dodd-Frank, the most high-profile and notable one is the Consumer Financial Protection Bureau (CFPB). The CFPB is intended to protect consumers from risky or abusive financial products. The bureau is empowered to regulate companies that sell financial products to consumers, and enforce laws against discrimination in consumer finance.
As the financial services industry was deregulated in the decades leading up to the crisis, more and more financial products were marketed and sold to consumers with little oversight by the legacy financial industry regulators. The rules covering credit reporting agencies, payday lenders, consumer loans, student loans and banking fees were opaque, and consumers were often being sold expensive, risky products they poorly understood.
The CFPB was conceived as a sort of “Food and Drug Administration (FDA)” that could clean up the excesses of the consumer finance industry. As part of its enforcement powers, the CFPB can fine lenders who act against its regulations and oversight. Consumers can also submit formal complaintsto the bureau, which gives it insights into issues consumers are experiencing and from whom.
4. The Volcker Rule
The Volcker Rule prevents banks from engaging in speculative trading activities. Named after former Federal Reserve Chairman Paul Volcker, the rule bars banks from engaging in proprietary trading, meaning agents or units of a bank cannot buy or sell securities, derivatives, commodity futuresor options in the banks’ accounts.
In the lead-up to the financial crisis, banks were creating and then trading highly risky derivatives, such as credit default swaps, most of which became such huge liabilities that they bankrupted entire financial institutions, such as the notorious case of AIG.
As one commentator famously saidof the Volker Rule, “What banking most needs is to become boring, the way the business was before bankers became addicted to trading profits.” Barring these types of risky investments means banks cannot use their own funds to make a profit.
Under the rule, banks can only trade when it’s necessary to run their business, such as currency trading. Banks can also trade when they’re working on behalf as an agent, broker or custodian for their customers. The rule also restricted banks from investing in or sponsoring hedge funds and private equity firms.
5. Monitoring Risky Derivatives
The Dodd-Frank Act enabled the Securities and Exchange Commission (SEC) to regulate derivative trading, or contracts between two parties who agree on a financial asset or a set of assets. These trades can involve the exchange of bonds, commodities, currencies, interest rates, market indexes or stocks. Regulators in charge of derivative trading can identify risks in the trades and take action before they trigger a financial meltdown.
6. Strengthening the Sarbanes-Oxley Act
The Sarbanes-Oxley Act, passed into law in 2002, was created in response to corporate scandals at publicly traded companies such as Enron. Sarbanes-Oxley reformed corporate responsibility, held CEOs personally responsible for accounting errors and gave protections to individuals who flag bad behavior, namely whistleblowers.
Dodd-Frank strengthened certain provisions under Sarbanes-Oxley. It established a bounty program where whistleblowers were entitled to 10% to 30% of the proceeds from successful litigation settlements that they inspire by reporting on bad behavior. It also extended the statute of limitations during which an employee can submit a claim against their employer, doubling it from 90 days to 180 days.
7. Requiring Hedge Funds to Register with the SEC
One major factor that drove the 2008 financial crisis was hedge funds making confusing and complex trades. The Dodd-Frank Act requires all hedge funds to register with the SEC. Additionally, hedge funds must provide key information about their trades and portfolios so the SEC can assess their overall risk.
8. Federal Insurance Office (FIO)
The FIO, which also exists under the Treasury Department, monitors all aspects of the insurance sector and makes sure insurance companies are following the law. Additionally, the FIO monitors how underserved communities and consumers have access to affordable non-health insurance products.
The office is responsible for identifying warning signs in the insurance markets that could indicate a collapse in the financial market.
Additionally, the FIO serves as an advisory member of the FSOC. This office works on an advisory level only and does not have any regulatory authority. The FIO works closely with the National Association of Insurance Commissioners (NAIC) and advises on important national and international insurance matters.
9. SEC Office of Credit Ratings
Dodd-Frank created the Office of Credit Ratings (OCR) at the SEC to oversee bond ratings agencies like Standard & Poor’s and Moody’s.
The credit ratings agencies help investors understand the risks involved in buying bondsand other credit instruments. These companies played a central role in the 2008 crisis by giving their best ratings to special financial products that repacked highly risky debt and were sold as safe investments.
The OCR administers rules for determining credit ratings for the protection of users and public interest, promoting accuracy in credit ratings and working to ensure credit ratings aren’t influenced by conflicts of interest and are subject to transparency and disclosure. The OCR can require the ratings agencies to disclose their methodologies and can take away an agency’s registration for making too many bad ratings calls.
How the Trump Administration Weakened Dodd-Frank
In 2017, former President Donald Trump described the Dodd-Frank Act as a “disaster” and promised to “do a big number” in terms of reforming it in the future. The Trump administration took several steps to weaken the law.
Watering Down Bank Regulation
In 2018, former President Trump signed into law a bill that made significant changes to the Dodd-Frank Act, including exempting some small and regional banks from its strictest regulations. The new law also weakened rules intended to protect big banks from collapse.
It dramatically reduced the number of banks subject to special Dodd-Frank treatment, including the number of banks that must undergo annual stress tests to demonstrate they can handle a severe downturn.
The administration said that the bill “rolls back the crippling Dodd-Frank regulations that are crushing community banks and credit unions nationwide. They were in such trouble. One size fits all—those rules just don’t work.”
Dismantling the CFPB
The Trump administration took the CFPB on a long and winding journey of deconstruction since 2017.
Former CFPB director Richard Cordray resigned in November 2017 due to what many have described as political pressure from the administration. Mick Mulvaney became interim director and slowly started to loosen restrictions by calling off an investigation into subprime lenders, firing the agency’s 25-member advisory board and siding with lenders in a lawsuit against the CFPB.
In 2020, the Supreme Court ruled the director can be fired at will by the president, but the bureau itself remains constitutional.
Loosening the Volcker Rule
In 2020, the Federal Deposit Insurance Corporation (FDIC) loosened restriction in the Volcker Rule. Under the revised regulation, bank capital requirements were lowered and banks were granted permission to make investments in venture-capital funds.
“While the intent of this statute is straightforward, it has been one of the most challenging post-financial crisis rules for both regulators and banking entities to implement,” said FDIC Chairman Jelena McWilliams in a statement. McWilliams added that the restrictions under the original rule were “inefficient” and “overly restrictive.”
One FDIC board member, Martin Gruenberg, a democrat, opposed the changes to the Volcker rule. Gruenberg said the changes leave the rule “severely weakened” and “risks repeating the mistakes” of the 2008 financial crisis.
The Dodd-Frank Act in Retrospect
The Dodd-Frank Act provides stronger oversight of numerous consumer and financial markets. Though some may argue that certain parts of its regulations are too restrictive, many agree that it was a necessary response to the 2008 crisis, helping to prevent another market meltdown in the future.
In a recent Brookings webinarthat reviewed the first decade of the Dodd-Frank Act, Senator Dodd commented on how valuable the law has been in recent history, especially during the coronavirus crisis.
“I think we would be in a far deeper mess today if we had not done what we did in 2010,” said Dodd. “Had we not provided the capital for liquidity, the stress test, today all of our financial services are playing a critical role in getting us back on our feet again.”
That’s not to say the law is perfect, though.Jeremy Stein, chairman of the department of economics at Harvard University, expressed disappointment during the webinar with how the law has been implemented more recently.
“I’m sorry to say my hope for stress tests as a wartime crisis tool has faded,” Stein said. “And that’s not in the rules, it’s how it’s implemented. It’s become a compliance exercise.”
Some prominent lawmakers say the Dodd-Frank Act has been effective up to this point, but it still doesn’t do enough. Former Federal Reserve Chair Janet Yellen expressed interest in implementing another broad regulatory reform in the future.
“I personally think we need a new Dodd-Frank,” Yellen said during the Brookings webinar. “We need to change the structure of FSOC and beef up its powers to be able to deal more effectively with all of the problems that exist within the shadow banking sector.”
