In 2008, the United States faced the most devastating financial crisis since the Great Depression, which lasted from 1929 to the late 1930s.
In response to the crisis, the Obama administration passed one of the most comprehensive financial reform bills that Americans had seen since the Glass-Steagall Act of 1933. This bill, introduced in 2010, was called the Dodd-Frank Wall Street Reform and Consumer Protection Act—typically shortened to the Dodd-Frank Act. Key objectives of the legislation were to enhance regulators' ability to monitor and address threats to financial stability, strengthen both the prudential oversight and resolvability of systemically important financial institutions (SIFIs), and improve financial markets' capacity and infrastructures to absorb shocks.
To protect consumers and identify threats, the Dodd-Frank Act reorganized the financial regulatory system. It assigned new powers and responsibilities to existing agencies, created new agencies and offices, and eliminated others. It also established the Orderly Liquidation Fund to help dismantle troubled financial companies placed in receivership and prevent tax dollars from being used to prop up such firms.
Let’s examine more closely some of Dodd-Frank’s major provisions, their impact on financial institutions, and some recent changes you need to be aware of.
5 Major Provisions Under the Dodd-Frank Act for Banks
The Dodd-Frank Wall Street Reform and Consumer Protection Act is an extraordinarily complicated financial reform bill that profoundly impacts all major segments of the financial services industry. Dodd-Frank enacted rules for:
- Increased capital and liquidity and required the use of stress testing to measure the adequacy of capital and liquidity
- Regulating derivatives
- Living wills and liquidation authority
- Reduced short-term funding and counterparty exposure
- Protection of financial consumers and investors
- Predatory conduct
- Prohibiting proprietary trading by taxpayer-backed banks
- Enhanced supervision and regulation of systemically important banks and nonbanks
- Whistle-blower protection and rewards
Due to its sweeping nature, Dodd-Frank made a far-reaching and substantial impact on the financial services sector, and regulators and financial institutions alike are still adapting. For financial institutions, compliance with the myriad of regulatory changes has been daunting, at times confusing, and very expensive.
Many politicians and bankers alike opposed the restrictive regulatory requirements the new bill placed on most banks. They argued that too much red tape negatively affected smaller, community banks and made it impossible for them to compete with the larger financial institutions. Many critics focused on specific sections of the statute, such as the Volcker Rule. Others were concerned with topics that Congress failed to include, such as reforming Fannie Mae and Freddie Mac.
Siding with the critics in 2018, the U.S. Congress passed a bill named the Economic Growth, Regulatory Relief, and Consumer Protection Act. It rolls back significant portions of the Dodd-Frank Act. Some of the changes include:
Small Lenders: The law exempts lenders with assets of $10 billion or less from Volcker rule requirements and imposes less stringent capital norms and reporting for small lenders.
Small and Regional Banks: The law revises the Dodd-Frank regulations for small and regional banks. For instance, it increases the asset threshold to apply prudential standards to $250 billion. Banks under $100 billion in assets are exempt from supervisory stress tests, and all banks under $250 billion are exempt from company-run stress tests. The Act also raises the threshold from $10 billion to $50 billion for mandatory risk committee requirements.
Large Custodial Banks: For institutions with custody of client assets but do not function as lenders or traditional bankers, the new law provides lower leverage ratios and capital requirements.
Mortgage Credit: The law exempts escrow requirements for residential mortgage loans held by a depository institution or credit union under certain conditions, including assets of, or under $10 billion. Also, it directs the Federal Housing Finance Agency to establish standards for Freddie Mac and Fannie Mae and consider some alternative methods for credit scoring.
Credit Bureaus: It may currently cost you a fee to place and remove a credit freeze, depending on the state in which you live. The revised Dodd-Frank act allows individuals to place and remove freezes on their credit files at no cost. Also, individuals can currently contact the credit bureau to set an initial fraud alert for 90 days. The revision extends the 90 days to a year.
The Dodd-Frank Act roughly doubled the number of regulations applied to U.S. banks, which increased their compliance costs by billions every year. Noncompliance costs are even higher. Financial institutions face various consequences, such as litigation, fees, and heavy enforcement actions from one or more regulatory agencies for noncompliance.
Here are five of Dodd-Frank's major provisions your financial institution needs to stay on top of:
1. The Volcker Rule
The Volcker Rule prohibits banks from investing in, owning, or sponsoring private equity funds, hedge funds, or engaging in proprietary trading operations for profit, with some exceptions. Its goal is to protect bank customers by preventing banks from making the same type of speculative investments that contributed to the 2008 financial crisis.
The Federal Reserve, FDIC, OCC, CFTC and SEC, modified the Volcker Rule Regulations effective October 1, 2020. The changes included eliminating Volcker Rule compliance responsibilities for banks below $10 billion in assets, with liabilities and trading assets capped at 5% of total assets. Generally, Community banks are exempt from the Volcker rule by statute.
Under the revised rule, changes include scrapping an unpopular proposed accounting measure while revising the standard used to determine which trades are prohibited. Firms without significant trading activities have simplified compliance requirements. Firms with significant trading activity have more stringent compliance requirements.
They clarified “covered funds” under the Volcker Rule, allowing banks to engage in previously banned investment instruments, including credit funds, venture capital funds, customer facilitation funds, and family wealth management vehicles.
2. Derivatives Regulations
In general, Title VII of the Dodd-Frank Act divided regulatory authority over swap agreements between the Securities and Exchange Commission (SEC) and Commodities Future Trading Commission (CFTC) except for certain excluded transactions.
It gave the SEC regulatory authority over “security-based swaps.” It gave the CFTC primary regulatory authority over all other swaps. In addition, it gave the SEC anti-fraud enforcement authority over swaps except for “security-based swap agreements.” The regulation of transactions that are both swaps and security-based swaps, so-called “mixed swaps,” falls under the joint jurisdiction of both Commissions.
Dodd-Frank not only regulates swap transactions but, to various degrees, the parties who enter into swap transactions. Historically, market participants privately negotiated most swaps, and some still are. These OTC trades are negotiated and carried out by private parties vs. a formal exchange, such as through the New York Stock Exchange. Dodd-Frank imposed a mandatory clearing requirement on many swap transactions. Swaps with standardized terms and high liquidity levels, and certain interest rate swaps and credit are subject to mandatory clearing. There are exceptions for certain market participants, but generally, financial institutions, asset managers, and investment vehicles would not fall into this category.
Asset-backed securities or mortgage-backed securities loaded up with subprime loans played a central role in the financial crisis and wiped out trillions of dollars in wealth. Rising interest rates burst the housing market bubble. Many homeowners defaulted on sub-prime, interest-only mortgages. Large amounts of certain derivatives linked to those mortgages got wiped out.
Banks create an asset, or mortgage-based security by buying and bundling loans – such as residential mortgage loans. Their complex nature made parts of them worthless, but no one knew which parts, and the uncertainty led to the secondary market shut-down. Banks started hoarding cash and stopped lending to each other, thus prompting the bank bail-outs. In response to this debacle, Dodd-Frank mandated clear documentation as to what is in each mortgage-based security. Also, lenders involved with mortgage lending must have a stake in the MBS process or risk retention.
3. The Financial Stability Oversight Council
Financial Stability Oversight Council is an inter-agency body that monitors and mitigates emerging risks to the U.S. financial system that could derail the economy. It monitors regulatory gaps and overlaps to identify emerging sources of systemic risk and ensures greater coordination among the nearly two dozen financial regulators.
The FSOC also promotes market discipline by disabusing expectations that the government will shield them from losses in the event of failure.
The FSOC generally does not have direct regulatory authority. Its role is to make policy recommendations to member agencies where authority already exists or to Congress where additional authority is needed.
4. Capital and Liquidity Requirements
Before the crisis, some banks had as low as $1 to every $50 in liabilities. When mortgage values dropped, it wiped out their balance sheets, hence the bail-outs.
Dodd-Frank set new rules about how much of a capital cushion banks need to prevent a recurrence. Capital and liquidity requirements established by the Federal Reserve mandated new standards for the type and amount of capital that depository institutions and banks must have to protect against exposures.
Largest institutions such as Bank of America, Citibank, and Goldman Sachs must hold up to 9.5% of their assets in liquid assets, such as cash, government bonds, or other low-risk assets.
The 2018 regulatory reform ordered the Fed to reduce the burden on community and regional lenders. It establishes tiers of regulations for larger U.S. banks. Domestic banks, under $700 billion in assets, get some degree of relaxed capital and liquidity rules. The new law allows the Fed to tie stricter rules more closely to risks and retains the most stringent requirements for the largest firms.
5. The Consumer Financial Protection Bureau
This Bureau is an independent agency within the Federal Reserve Board (FRB). When established, the agency had wide-ranging consumer education responsibilities to provide guidance on financial matters and ensure that consumers could access information about their financial options.
The CFPB conducts studies on consumer financial products and services such as credit cards, mortgages, student, payday, and auto loans as well as collection agencies. It has the power to make and enforce rules and regulations for financial institutions and products and issue orders. It accepts and processes direct consumer complaints through its consumer response operations and has the authority to investigate and enforce, with power to issue subpoenas and request testimony in federal court.
The future of the CFPB is in doubt. The unpopular industry watchdog has come under political fire during this administration and has experienced considerable changes. The original appointed director resigned in 2017. The President appointed someone who was openly hostile to the agency to act as interim director. After about a year, he handed the crippled agency over to his successor. This appointed director plans to follow in his footsteps.
This year, the Supreme Court, rejecting the federal law that sought to place limits on presidential oversight of independent agencies, ruled that the agency's structure violated the separation of powers. While the decision did not dismantle the CFPB entirely, it did grant the President authority to remove its director at will.
The Seila decision fundamentally exposes the Bureau to enhanced political pressure, particularly from the President and the executive branch. These pressures will likely impact the work of the Bureau.
We could fill a book with all Dodd-Frank's details and their implications for the financial industry. Our goal for this article is to highlight and note the latest changes to some of the most critical rules enacted by this piece of legislature to help you keep your financial institution in compliance with this exhaustively comprehensive law.
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