The Dodd-Frank Act explained

After every major financial crisis over the past century, policymakers in the executive and legislative branches of the United States government have passed sweeping legislation to overhaul the way banks do business.

The Panic of 1907 prompted the Federal Reserve Act of 1913, which created our central bank. The Great Depression led to the Glass-Steagall Act of 1933, which established the Federal Deposit Insurance Corporation and prohibited the cohabitation of investment and commercial banks. And the litany of crises throughout the 1970s and 1980s convinced Congress to broadly deregulate the bank industry through a series of wide-ranging legislative acts.

It's only through this lens of historical context that one can truly appreciate the Dodd-Frank Act of 2010, which came on the heels of the financial crisis that erupted two years earlier.

Fighting the last war

Generals are often accused of "fighting the last war," in that they set their strategies going forward based on their most recent combat experience. This can be a mistake, of course, because times change. Strategies evolve. Adversaries adjust. Weapons systems advance. The same can be said of the intent behind the Dodd-Frank Act, which was conceived with the best of intentions.

Fissures in global financial markets were first exposed in August 2007 when a leading bank in Europe, France's BNP Paribas, stopped allowing investors to withdraw capital from two funds that held mortgage-backed securities. The situation escalated seven months later when Bear Stearns experienced a liquidity crisis. The investment bank's institutional clients stopped providing the funds the bank needed to stay afloat. Things got so dire that the federal government offered JPMorgan Chase (NYSE: JPM) a $30 billion loan to facilitate its acquisition and thus rescue.

But it wasn't until September 2008 that the crisis climaxed with the failure of Lehman Brothers, the nation's fourth-biggest investment bank at the time. The stock market plummeted. Credit markets froze. And countless companies, both within the financial sector and outside of it, found themselves on the brink of failure. The fear pulsing through the credit markets was particularly alarming because it made it impossible for even the most creditworthy of companies such as General Electric to access the funds needed to cover its payroll and other ordinary operating costs.

The government's initial response was swift. It arranged Bank of America's (NYSE: BAC) purchase of Merrill Lynch. It nationalized all but a small sliver of American International Group, the massive insurance company that had insured vast swaths of investment securities backed by subprime mortgages. And it injected tens of billions of dollars' worth of capital into the nation's leading banks, including JPMorgan Chase, Bank of America, Citigroup (NYSE: C), and Wells Fargo (NYSE: WFC).

These were stopgap measures, however, more akin to CPR than to a long-term solution to cardiac problems. The latter came in the form of the Dodd-Frank Act, which was passed two years later in a heavily partisan vote spearheaded by Democrats and opposed by Republicans. "The White House will call this a victory," said then-Senate Minority Leader Mitch McConnell, R-Ky. "But as credit tightens, regulations multiply, and job creation slows even further as a result of this bill, they'll have a hard time convincing the American people that this is a victory for them."

The too big to fail problem

The Dodd-Frank Act was designed to ensure that a financial crisis like that in 2008 won't happen again. As such, it sought to attack the principal problem that policymakers believed had caused the crisis in the first place – the growth and proliferation of too-big-to-fail banks.

The notion of banks being too big to fail has a rich history. Almost all of the greatest financial crises in American history were aggravated by the failure of large financial institutions, which further sapped confidence in the financial sector and, prior to the Federal Deposit Insurance Corporation's founding, led to the destruction of countless peoples' liquid wealth. This is why the eponymous founder of JPMorgan Chase worked tirelessly during the Panic of 1907 to stop the bank runs occurring up and down Wall Street at the time. His actions were vindicated 25 years later when an otherwise ordinary recession transformed into the Great Depression due to a tsunami of bank failures.

But it wasn't until 1984 that the term "too big to fail" became part of our broader lexicon with the failure of Continental Illinois, one the country's largest banks at the time. In an almost identical series of events to the ones that brought down Bear Stearns more than 30 years later, Continental Illinois saw its funding sources evaporate after rumored problems at the bank led institutional investors to empty their accounts.

Explaining the Dodd-Frank Act

In an effort to prevent crises like these in the future, the policymakers behind the Dodd-Frank Act underwrote a series of critical reforms. The act increases the amount that capital banks must hold in reserve, giving the banks an added cushion to absorb loan losses in future downturns. It similarly requires banks to keep a larger portion of their assets invested in things that can be easily liquidated in the event of a bank run – namely, cash and government securities as opposed to term loans.

The act also subjects the nation's biggest banks to a series of heightened regulatory requirements not faced by regional and community banks. Under Dodd-Frank, every bank with more than $50 billion worth of assets on its balance sheet must submit to annual stress tests administered by the Federal Reserve, which then determines if they would survive a hypothetically severe crisis akin to the one in 2008. As a part of the stress tests, these banks must also seek regulatory approval to increase their dividends or authorize new share repurchase programs.

Even among the biggest banks, moreover, the Dodd-Frank Act makes distinctions. The biggest among them are classified as global systemically important banks, or G-SIBs, which must hold an additional tranche of capital, known as the G-SIB surcharge. This is particularly burdensome for JPMorgan Chase, Bank of America and Citigroup which have to keep as much as 3% their shareholders' equity laying fallow in cash or low-yielding but highly liquid securities. These banks must also submit resolution plans to regulators each year, detailing how they could be resolved without causing harm to the financial markets in the event they go bankrupt.

The Dodd-Frank Act has reintroduced central tenets of the Glass-Steagall Act as well, which had been gradually eroded over the years after originally forbidding commercial banks from running trading operations. The iteration of the rule in Dodd-Frank, known as the Volcker Rule, outlaws proprietary trading at universal banks and thereby limits their trading operations to serving as market makers for institutional clients. And last but certainly not least among the major changes introduced by the Dodd-Frank Act was the founding of the Consumer Financial Protection Bureau, which is vested with the authority to protect consumers from unfair, deceptive, or abusive financial products and services.

At the end of the day, in turn, while one can argue about the prescience and necessity of the Dodd-Frank Act, there's simply no doubt that it has fundamentally transformed the banking and financial services industry. The main question now is whether or not this transformation will be permanent, or, as has been promised by policymakers of late, just a temporary blip in the history of banking that could soon go away.

John Maxfield owns shares of Bank of America and Wells Fargo. The Motley Fool owns shares of General Electric. The Motley Fool has a disclosure policy.

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President Trump met with business leaders in the State Dining Room at the White House on Friday. Credit Al Drago/The New York Times

Trump Moves to Roll Back Obama-Era Financial Regulations

President Trump on Friday moved to chisel away at the Obama administration’s legacy on financial reform, announcing a series of steps to revisit the rules enacted after the 2008 financial crisis and setting the stage for a showdown with Democrats over the future of Wall Street regulation.

After a White House meeting with business executives, Mr. Trump signed a directive calling for his administration to identify potential changes to provisions of the Dodd-Frank Act, crafted by the Obama administration and passed by Congress in response to the 2008 meltdown. A second directive he signed will effectively halt an Obama-era Labor Department rule that requires brokers to act in a client’s best interest, rather than seek the highest profits for themselves, when providing retirement advice.

The executive order impacting Dodd-Frank is vague in its wording and broad in its reach; it never mentions the Dodd-Frank law by name, instead laying out “core principles” for regulating the financial system, including empowering American investors and enhancing the competitiveness of American companies. But it amounts to a broad grant of authority to the Treasury Department to find ways of restructuring major provisions of Dodd-Frank, directing the secretary to conduct a sweeping review of existing laws and make sure they align with the administration’s goals.

Mr. Trump’s action on the fiduciary rule will have a more immediate impact. His memorandum directs the Department of Labor to review whether the rule may “adversely affect” investors’ ability to access financial advice — and if it does, he authorized the agency to rescind or revise the rule.

The rule’s supporters, including Democratic lawmakers and consumer groups, describe it as a basic consumer protection that can prevent brokers from taking advantage of vulnerable clients. The industry argues, however, that the rule will expose it to a torrent of lawsuits and will lead firms to pass on the costs to consumers.

Taken together, the president’s actions constitute a broad effort to loosen regulations on banks and other major financial companies, put into motion by a president who campaigned as a champion of working Americans and a critic of Wall Street elites. On Friday, Mr. Trump said his actions were intended to help both Wall Street and workers as his administration eases constraints on banks and enables them to lend to companies, which could then hire more workers.

“We expect to be cutting a lot out of Dodd-Frank because frankly, I have so many people, friends of mine that had nice businesses, they can’t borrow money,” Mr. Trump said in the State Dining Room during his meeting with business leaders. “They just can’t get any money because the banks just won’t let them borrow it because of the rules and regulations in Dodd-Frank.”

As he announced his goals on financial deregulation, Mr. Trump sat beside Stephen A. Schwarzman, the chief executive of the private equity giant the Blackstone Group and the chairman of his business council, who said the panel would “advise the government on the areas where we could do things a lot better in our country, for all Americans.”

The president had praise for Jamie Dimon, whose bank, JPMorgan Chase, was often a target of regulatory actions by the Obama administration.

“There’s nobody better to tell me about Dodd-Frank than Jamie, so you’re going to tell me about it,” Mr. Trump said.

The meeting underscored the degree to which the architects of Mr. Trump’s economic strategy are now some of the people he denounced in his campaign, which ended with a commercial that described “a global power structure that is responsible for the economic decisions that have robbed our working class, stripped our country of its wealth and put that money into the pockets of a handful of large corporations.”

The advertisement included an image of the chief executive of Goldman Sachs, which has become a virtual feeder for top Trump administration officials. Steven Mnuchin, his nominee for Treasury secretary, is a former Goldman Sachs trader and a hedge fund manager. Gary Cohn, the chairman of his national economic council, was Goldman’s No. 2 executive, and Stephen K. Bannon, Mr. Trump’s chief strategist, is a former Goldman banker.

The president’s actions came just hours after congressional Republicans voted to repeal an unrelated Dodd-Frank rule, a sign that Mr. Trump will have the support he needs on Capitol Hill to upend a law he has called “a disaster,” and promised to do “a big number” to reshape.

While the president cannot unwind Dodd-Frank with the stroke of a pen, his orders set the tone for the regulatory agencies enforcing the rules, including the Securities and Exchange Commission. And the orders, which Democrats and consumer groups immediately denounced as gifts to the Wall Street companies that ignited the 2008 crisis, could portend even more executive actions that direct the regulators to halt financial regulation.

The actions are the latest sign that Mr. Trump, despite striking a populist tone during the campaign, is working to accommodate Wall Street and other corporations.

“The administration apparently plans to turn over financial regulation to Wall Street titan Goldman Sachs, and make it easier for them and other big banks like Wells Fargo to steal from their customers and destabilize the economy,” said Lisa Donner, executive director of Americans for Financial Reform, an advocacy group that supports Dodd-Frank. “That betrays the promises Trump made to stand up to Wall Street, and it will have dire consequences if he’s successful.”

The president’s deference to the visiting executives — he also heaped praise on Laurence D. Fink, the head of the investment firm BlackRock, for managing money for the Trumps and earning “great returns” — sharply contrasts with his predecessor. President Barack Obama once remarked that “I did not run for office to be helping out a bunch of fat cat bankers on Wall Street.”

Following the new president’s lead, congressional Republicans on Friday started chipping away at Dodd-Frank, one of Mr. Obama’s signature achievements. The Republicans used an unusual parliamentary procedure to repeal a rule that stems from the law with only a majority of votes rather than the 60 votes needed to overcome a filibuster.

The Senate voted 52 to 47 to void the rule, which requires oil companies to publicly disclose payments they make to governments when developing resources around the world. The rule, which Dodd-Frank assigned to the Securities and Exchange Commission to enforce, was tangential to Dodd-Frank’s mission of reforming Wall Street, but lawmakers included it anyway with the hope of exposing bribes and corruption.

Some of the largest American oil companies objected to the S.E.C. rule, including Exxon Mobil, arguing that it put them at a competitive disadvantage with foreign companies. Rex W. Tillerson, Mr. Trump’s secretary of state, personally lobbied against it when he was the top executive of Exxon Mobil, according to public accounts.

“Big Oil might have won the battle today, but I’m not done fighting the war against entrenched corruption that harms the American people’s interests and leaves the world’s poor trapped in a vicious cycle of poverty while their leaders prosper,” said Senator Benjamin L. Cardin of Maryland, the top Democrat on the Senate Foreign Relations Committee, who along with former Senator Richard Lugar, a Republican, sponsored the amendment in Dodd-Frank requiring the S.E.C. to write the oil disclosure rule.

Friday’s Senate vote, which came after the House voted to repeal the rule, was the congressional Republicans’ opening salvo on Dodd-Frank. As long as President Obama was in power, Republicans had limited ability to attack Dodd-Frank, which was enacted in 2010. In 2014, they managed to gut a financial derivatives rule as part of broader spending bill, but other tweaks have been relatively modest.

Now emboldened, House Republicans are also moving legislation to “repeal and replace” Dodd-Frank, though they would need 60 votes to accomplish that. And they are considering potential ways to use the budget process to defund some aspects of the law, all of which comes on top of the president’s executive actions.

Wall Street is expected to lobby Mr. Trump’s financial regulators, at the S.E.C. and elsewhere, to modify rules and enforce them lightly. This effort could drag on for years.

President Trump, however, wasted no time declaring war on Dodd-Frank. After calling the law “a disaster” on Monday, the president on Friday signed the directive instructing the Treasury Department and financial regulators to construct plans to revise Dodd-Frank. An order like that could empower the regulators to tweak the rules.

But there is a limit to what the regulators can do. Dodd-Frank is still the law, and it requires the regulators to enforce hundreds of Dodd-Frank rules. Under administrative law, the regulators must also formally propose any new rules and seek public comment.

The Trump administration may have an easier time voiding the Obama-era Labor Department rule requiring brokers to act in a client’s best interest when providing retirement advice. That rule is not explicitly part of Dodd-Frank.

“President Trump’s action will make it harder for American savers to keep more of what they earn,” Senator Sherrod Brown, the ranking Democrat on the Senate Banking Committee, said in a statement. “Families who are struggling to save and invest for a secure retirement now have to worry that financial institutions aren’t putting their customers’ interest first.”

With the oil company disclosure rule, Republicans started smaller, using an obscure law to undo it.

Under the Congressional Review Act of 1996, Congress has at least 60 days to introduce legislation disapproving major new regulations — and can ultimately repeal these regulations with only 51 Senate votes, rather than the normal 60 needed to overcome a filibuster.

The Congressional Review Act offers Republicans a narrow window to act on a dozen or so Dodd-Frank rules that were recently completed. Republicans may target a financial derivatives rule adopted last year by the Commodity Futures Trading Commission, a Consumer Financial Protection Bureau rule for prepaid debit cards and a rule approved by banking regulators that imposed capital requirements for banks that trade derivatives.

Until now, this tactic has led to a repeal measure being signed into law only once, in 2001, when Republicans and President George W. Bush wiped out workplace safety regulations adopted near the end of President Bill Clinton’s administration.

The Congressional Research Service has determined that rules sent to Congress on or after June 13 of last year are vulnerable to repeal under the Congressional Review Act. The S.E.C. rule just missed that cutoff; it became final on June 27, making it fair game for Republicans to repeal, over the objections of antipoverty groups like Oxfam and the One Campaign, co-founded by Bono, the lead singer of U2.

“If President Trump is serious about his promise to ‘drain the swamp’ and protect American security, he will veto this dangerous bill immediately,” Isabel Munilla, an Oxfam official, said in a statement.

The president is expected to sign the bill.


With A Stroke Of The Pen, Donald Trump Aims To Wave Goodbye To The Dodd Frank Act

When taking the White House, President Donald Trump vowed to do a “big number on Dodd Frank,” the sweeping banking legislation put in place by the administration of President Barack Obama in response to the 2008 financial crisis. President Trump called Dodd Frank “a disaster” that has impeded growth by making it harder for banks to lend to consumers and small businesses. Still in his second week in office, Trump is making good on his statement.

On Friday afternoon, he signed an executive order which he said would dramatically scale back the Dodd Frank Act. “Today we are signing core principles for regulating the United States financial system,” Trump said when signing the order. Earlier in the day, Trump said he expected “to be cutting a lot out of Dodd Frank.”

The executive order, released late in the day, offered broad principles to foster economic growth, vibrant markets and enable U.S. corporations to compete with foreign counterparts. It further characterized the prevention of taxpayer bailouts and a restoration of public accountability within federal financial regulatory agencies as priorities. Trump directed his Treasury Secretary nominee to draft a report within 120 days identifying laws, treaties and regulations that conflict with his principles.

While broad, Trump’s order lays the groundwork for sweeping change to current law and, if successfully pushed through Congress, could eventually lead to a replacement of Dodd Frank.

The Act, signed into law in 2010, re-shaped Wall Street and the American banking industry. For America’s largest lenders, it forced firms to undergo a host of new regulatory exams and pare back their lucrative but illiquid private equity and hedge fund investments. Some mid-sized banks felt the weight of Dodd Frank, as firms with over $10 billion in assets and $50 billion in assets were subjected to increased surveillance.

It also created new regulatory agencies such as a Financial Stability Oversight Council (FSOC), which aimed to resolve large failing firms, for instance another Lehman Brothers, without a government bailout or next crisis. It also spawned the Consumer Finance Protection Bureau, an agency dedicated to guarding against abusive or misleading retail financial products. This regulatory regime, however, is now poised to change dramatically.

“We have the best, most highly capitalized banks in the world, and we should use that to our competitive advantage. But on the flip side, we also have the most highly regulated, overburdened banks in the world,” Trump’s White House National Economic Council Director Gary Cohn said in an interview with the Wall Street Journal.

Trump’s executive order “is a table setter for a bunch of stuff that is coming,” said Cohn, who recently left investment bank Goldman Sachs, where he was second in command to CEO Lloyd Blankfein for a decade.

The biggest early area of focus is likely to surround the FSOC, which Cohn said had not succeeded in building a system to resolve a failing bank without either government aid, or posing a risk to the financial system writ large. This, however, will face stiff opposition from Democrats and proponents of bank regulation.

Trump may find bi-partisan support for regulatory relief on small and mid-sized banks. Bankers complain of expensive and unwieldy new regulatory burdens on these firms, which they say curtails lending to small businesses and local communities.

“While some targeted relief to community banks is appropriate, we cannot afford to undo Dodd Frank’s essential safeguards,” said U.S. Sen. Mark R. Warner (D-VA), a member of the Senate Banking Committee.

Rethinking The Volcker Rule

Other areas of early focus will surround the Volcker Rule, a mandate named after former Federal Reserve chair Paul Volcker, which restricted banks from proprietary trading and limited their ability to make hedge fund and private equity investments. Trump’s Treasury Secretary nominee Steven Mnuchin, another former Goldman partner, has said he would look to amend the rule.

While aimed at limiting risk on Wall Street, especially in the opaque and leveraged areas of capital markets that made the credit crisis so violent, the Volcker Rule led to enormous backlash.

Investors and bank chieftains complained that it never truly defined the difference between proprietary trading and market making, where trading firms hold out bids and offers across financial markets and hold short term inventories of assets to accommodate transactions. As a consequence, many banks simply stepped back from making markets, creating illiquidity that investors believe has exacerbated price swings, particularly in assets like junk bonds and leveraged loans. Undoing or amending the rule would have dramatic ramifications on Wall Street.

Going back to old trading standards would likely gin the operations of America’s largest banks such as Cohn’s former employer Goldman Sachs, JPMorgan, Bank of America, Morgan Stanley and Citigroup. Moreover, it might begin to turn a dramatic shift in the balance of power on Wall Street. Due to the Volcker Rule, some of the best investing talent fled hamstrung brokerages for less regulated entities such as hedge funds and private equity firms.

The years since the crisis allowed private equity firms like Blackstone, Apollo, KKR and Carlyle to expand in businesses like real estate investing, where investment banks once were forceful competitors, and it all but exited firms from the leveraged buyout business. Goldman Sachs and Morgan Stanley were once the breeding ground for quantitative traders such as Citadel’s Ken Griffin, AQR’s Cliff Asness and PDT Partners’ Peter Muller, but these types of operations were shuttered entirely, or spun out.

Although Dodd Frank restrictions led to a malaise on Wall Street, it also meant the years since the crisis were marked with stability and minimal volatility.

When oil prices plunged two years ago, no major investment bank was saddled with large losses.  The same holds true for recent freezes in speculative grade credit, or volatility in currencies. As bouts of financial contagion spread in Europe in recent years, investors have never felt the tumult would jeopardize any major Wall Street firm because of their years of retaining profits to rebuild capital.

Trump’s Main Street Financial Overhaul

Change to Dodd Frank won’t just impact the highest rungs of finance. Since Trump was elected, banking industry trade associations have lobbied for a rollback of oversight on smaller lenders.

Presently, banks exceeding $10 billion in assets are subjected to increased oversight, and those with $50 billion in assets can be deemed a systemically important financial institution and put under exams administered by the Federal Reserve such as stress tests. A day after the election, Tom Michaud, CEO of financial sector investment bank Keefe, Bruyette & Woods told FORBES he’d like to see an increase of SiFi designations to just banks with $250 billion in assets and above.

Such relief might have a potent impact on Main Street because it would dramatically reduce overhead costs for small and mid-sized lenders, potentially giving them greater financial flexibility to make small business and consumer loans. More broadly, bank CEOs like JPMorgan’s Jamie Dimon have said regulatory relief could increase the flow of money into the broader economy.

“I do think if there’s some regulatory relief, you will see banks be more aggressive and growing, opening branches in new cities, adding to loan portfolios, seeking out clients they don’t have. So I’m hoping that we’ll see a little bit of that too, but that will wait for a little regulatory relief,” Dimon told investors on Jan. 13.

Said Cohn of the looming change, “it has nothing to do with J.P. Morgan, it has nothing to do with Citigroup. It has nothing to do with Bank of America. It has to do with being a player in a global market where we should, could and will have a dominant position as long as we don’t regulate ourselves out of that.”

Trump’s executive order will revisit a mandate imposed by the Department of Labor called the fiduciary rule, which seeks to hold investment advisers to a standard of acting in their clients best interests. This rule, set to go in effect in April, will be repealed, Cohn said, because it will limit consumer choice. The DoL said late on Friday it will “consider its legal options to delay the applicability date as we comply with the President’s memorandum.”

Consumer Protection Agencies On The Chopping Block

Finally, it appears the Trump administration may seek to replace CFPB head Richard Cordray, in a first step towards neutralizing the regulatory agency.

Only months ago, the CFPB led an investigation into Wells Fargo that revealed the bank had created thousands of fake savings and credit card accounts without the consent of consumers. When employees raised their voices against these practices, they were fired. The scandal rocked Wells Fargo, leading to the quick resignation of CEO John Stumpf, and it spawned a host of regulatory investigations.

The CFPB has also played prominently in combating usury, improper foreclosure practices, and payday loans that can leave the poor under a mountain of debt. The Trump administration, however, feels the CFPB has over-reached and made businesses hesitant to grow.

Cohn further hinted that he and Treasury Secretary Mnchin are prepared to overhaul Fannie Mae and Freddie Mac, two housing agencies that guarantee the vast majority of prime mortgages in the United States but were put into government conservatorship in 2008.

“I’m not sitting here saying we want to go back to the good old days,” Cohn told the WSJ of the planned overhaul. He said the Trump administration could write better, more efficient regulations and also expressed confidence that the market – smarter from the lessons of the crisis – would be able to regulate itself as restrictions were loosened.

Democrats will fight Trump’s deregulatory push, and it is too be seen whether a rollback will be so easy to pull off. Even in the wake of a severe crisis that germinated from Wall Street, it took years of battle to sign Dodd Frank into law. Furthermore, current heads of many agencies who were nominated by President Obama will be tasked with reforms.

“In the short-run, rules changes will need support from the heads of regulatory agencies who were appointed by President Obama and we think will slow down this process,” said Brian Gardiner, an analyst covering public policy for KBW.

Federal Reserve chair Janet Yellen has another year on her term. Comptroller of the Currency Thomas Curry’s term ends in April, while Federal Deposit Insurance Corporation chair Martin Gruenberg’s term expires in November. Cordray, of the CFPB, has nearly 18-months remaining on his term, potentially allowing regulators to slow walk Trump’s executive orders.

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