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In 2008, a perfect storm of factors led to a global financial crisis.
Lack of regulation, irresponsible mortgage lending that brought about a wave of foreclosures, and the packaging of those bad mortgage loans into investment products sold as safe investments to unwitting buyers resulted in the Great Recession.
The Dodd-Frank Act — named for its sponsors, Sen. Chris Dodd and Rep. Barney Frank — was signed into law in 2010 in response to the actions that sparked the financial crisis. The law was passed for four primary purposes.
- To promote financial stability
- To improve accountability and transparency in the U.S. financial system
- To end the perception of some financial institutions being “too big to fail”
- To protect American consumers from abusive practices by financial service providers
To achieve these aims, Dodd-Frank created the Consumer Financial Protection Bureau, established a Financial Stability Oversight Council and an Office of Financial Research, and imposed new restrictions and requirements on financial institutions like banks and hedge funds. Dodd-Frank also gave the Securities and Exchange Commission broader authority, including the ability to regulate certain types of derivatives (a type of risky investment) and to more closely regulate credit-rating agencies.
- Dodd-Frank and the financial crisis
- What did Dodd-Frank do?
- How does the Dodd-Frank Act help you as a consumer?
- The Dodd-Frank Act is controversial — and some of its protections have been rolled back
Dodd-Frank and the financial crisis
The story of the financial crisis starts with deregulation. Over many years, rules regulating the financial industry, especially banks, were loosened — in part because of a belief that free markets are self-regulating. Lax rules left certain financial institutions largely free to chase profits without strong oversight.
Unfortunately, a number of financial institutions behaved improperly while chasing those profits. Mortgage lenders made trillions of dollars of mortgage loans to high-risk borrowers. This spurred builders to build more and more homes, which led to more people with risky credit profiles taking out mortgages — a vicious cycle that led to the creation of the housing bubble.
These loans were repackaged into investments called mortgage-backed securities. Credit-rating agencies rated most of these investments as low risk, because foreclosure rates traditionally have been low. Investors around the world purchased these mortgage-backed securities.
Banks had high exposure to the bad mortgages and borrowed heavily against the value of mortgage-backed securities. Eventually the housing bubble burst as supply outpaced demand. Suddenly, properties that were funded by these risky mortgages weren’t worth the cost of the loans.
When homeowners stopped paying mortgages and started losing homes, a foreclosure crisis ensued and property values tumbled. This caused millions of investors to lose money, with financial institutions and insurers either going bankrupt or needing bailouts.
The government wanted to prevent this from happening again, so the Dodd-Frank Act was passed to address the key issues that led to the crisis.
What did Dodd-Frank do?
The Dodd-Frank Act attempted to systematically address many of the problems that led to the 2008 financial crisis. The law established …
- The Volcker rule to prohibit banks from making speculative investments. This rule basically forbids banks from having certain relationships with risky investment firms, like some hedge funds or private equity funds. It also prevents banks from making investments in risky assets, like derivatives, using the bank’s money. Banks are still allowed to do this on behalf of clients, but not for themselves.
- Tougher oversight of the financial industry. The Financial Stability Oversight Council was created and given the authority to identify risky practices of certain banks and other nonbank financial companies, even those outside the financial services marketplace.
- Tougher oversight of the insurance industry. A new Federal Insurance Office was created to monitor the insurance industry and identify regulatory gaps. The Federal Insurance Office is also tasked with recommending to the Financial Stability Oversight Council whether any particular insurer should be subject to additional oversight.
- Tougher oversight of credit rating agencies. An Office of Credit Rating was established within the Security and Exchange Commission to ensure that ratings of investment vehicles (like the mortgage-backed securities that led to the financial crisis) aren’t affected by conflicts of interest, to promote accuracy in credit ratings, and to protect users of credit ratings by monitoring the practices of rating agencies.
- New regulations for high-risk financial products. Dodd-Frank gave the SEC new authority to regulate certain high-risk financial products — such as certain derivatives — that were common leading up to the financial crisis.
- The Consumer Financial Protection Bureau. The CFPB was established to regulate consumer financial products and services. The agency helps ensure that consumers are treated fairly by financial institutions by providing education for consumers to empower them to make good decisions in the financial marketplace, investigating complaints, proactively creating rules and fining bad actors.
- New protections for whistleblowers. New regulations were put in place to ensure that insiders could come forward and report wrongdoing within the financial services industry. Whistleblowers are protected from retaliation by their employer and may also be entitled to financial incentives.
Essentially, Dodd-Frank aimed to curb the behavior of financial institutions, insurers and credit rating agencies that caused the financial crisis — while also putting new protections for consumers in place.
How does the Dodd-Frank Act help you as a consumer?
Dodd-Frank helps consumers because everyone benefits from economic stability. Another financial crisis caused by irresponsible lenders could have global repercussions and lead to billions of dollars in losses, as the 2008 crisis revealed.
Consumers are also helped directly by the Consumer Financial Protection Bureau. The CFPB empowers consumers with tools to make informed decisions, takes actions against predatory companies and provides financial education. As of December 2016, the CFPB has provided more than $11.8 billion in relief to consumers through its supervisory and enforcement work, which includes helping consumers get their debts canceled or collect compensation from lenders who acted wrongfully.
The Dodd-Frank Act is controversial — and some of its protections have been rolled back
While Dodd-Frank aimed to fix serious financial problems, it was a controversial law from the start. While some say the law didn’t go far enough to rein in bad behavior, others see the financial regulations as overly burdensome, especially for small lenders.
Lawsuits challenged the constitutionality of the structure of the Consumer Financial Protection Bureau because the agency’s budget comes entirely from the Federal Reserve Board — as opposed to being subject to congressional funding — and because the director can act independently of what the president wants.
Continued opposition to Dodd-Frank has resulted in many of the law’s regulations being rolled back in the Economic Growth, Regulatory Relief and Consumer Protection Act. This act exempted smaller financial institutions from the Volcker rule and boosted the threshold of assets a bank and certain other non-bank financial companies can have before it’s considered “too big to fail” or “systemically important” and subject to tighter regulations.