Introduction

The Dodd-Frank Act is under threat. Republicans have long targeted the act, which was passed to strengthen and reform the US banking and financial system after the global financial crisis of 2008. Now they're acting to undermine it. In May, the House of Representatives took a step towards weakening Dodd-Frank Act by passing the Financial CHOICE Act, which repeals most of it. In addition, last week the Treasury released a summary of part of its proposal to weaken Dodd-Frank, which isn't as extreme as the Financial CHOICE Act, but still will have a large effect.

We expect that any bill that's debated in the Senate will look more like the Treasury proposal than the Financial CHOICE Act, but we don't know that yet. What we do know, though, is that Republicans will try to push through changes to Dodd-Frank that Wall Street wants, even if they make another catastrophic financial crisis more likely.

Financial regulation can be confusing; this explainer is intended to demystify it and to arm you with a framework and the context to understand the different proposals. The fight over Dodd-Frank repeal will be one of the big fights in the Senate this year; the RISE Stronger Economy & Jobs Policy Working Group hopes this explainer helps you be more effective in talking to your representatives about it and urging them to do the right thing.

I. Why is financial regulation important?

• Why are banks so important? Banks are the circulatory system of the economy.
  • The banking system gathers savings (like the money that we deposit in our bank accounts or money market accounts) and lends those savings for investment in productive activities.
    • Those loans help the economy grow.
      • They help businesses expand, produce more, and hire more people.
      • They also help people buy homes, which creates construction jobs and improves communities.
    • The interest on these loans goes, in part, to pay interest to the people who have deposited their money in the bank, giving people a return on their savings.
  • If banks are doing their job correctly, they move financial resources to the parts of the economy where they're most needed.
    • For example, if there's a lot of demand for products from a particular industry, companies in that industry will go to banks for loans to expand to meet that demand, and the banks will lend everybody's savings to help that industry.
    • If banks aren't doing their job correctly (for example if there's excessive regulation or corruption in the banking system), successful businesses will have trouble getting the money they need to grow, which hurts the economy.
  • Every industry is important, but the banking industry is especially important because it touches every part of the economy.
    
    • For example, if the auto industry isn't doing well, that hurts auto workers and people who depend on them, which is bad. But if the banking system has problems, that hurts people in every industry, because every industry depends on banks for capital.
    • History shows that it takes longer for the economy to recover from recessions caused by problems in the banking system than other types of recessions.
• The banking system, more than other industries, is prone to crisis.
  • The US has had a banking crisis on average once every eight years since 1800; other advanced economies have similar rates of crisis.[1]
  • One of the biggest reasons for this is that it's not always easy to tell when things in the banking system aren't going well.
    • If the auto industry is going into a crisis, it's easy to tell—people start buying a lot less cars. But historically, when the banking system goes into a crisis, things often look great right until the moment that they blow up.
    • This is because when the overall economy is strong, it's hard to tell if problems are building up in the banking system, because very few people default on their loans in a strong economy.
    • However, even though a strong economy makes it appear that there's not much risk in the banking system, it often encourages banks to take more and more risk in order to increase their profits, because it seems like nothing can go wrong.
      • For example, in the years leading up to the subprime mortgage crisis, banks kept on expanding subprime lending, because they could make more profits making subprime mortgages than conventional mortgages and default rates didn't seem to be much higher
  • As banks add risk, their vulnerability to even a small downturn in the economy increases.
    • During the subprime mortgage crisis, the average home price in the US decreased by around 18 percent.
      • If banks had stuck to making traditional mortgages with 20 percent down payments, they might not have lost any money at all.
      • But, because they'd made so many risky mortgages with much lower down payments, they took severe losses—and a crisis that might have been contained to the housing industry was transmitted through the weakness of the banking system to every industry.

• So, regulating the banking system is a very difficult challenge, because it's not easy to tell whether banks are taking excessive risks, but it's also a very important task, because a crisis in the banking system can bring down the entire economy.
  • History shows that the banking system can't regulate itself—if the government doesn't regulate it effectively, banks will take too much risk and eventually there will be a banking crisis.
  • Banking crises in the developed world have tended to follow periods of deregulation and financial liberalization—when banks have been given freer rein they tend to push the financial system into crisis.
  • An effective system of banking regulation needs to do a few things:
    • First and foremost, it needs to give regulators the tools they need to really understand the risks that banks are taking and to rein them in if these risks start to get excessive.
    • It needs to give regulators the flexibility to look at banks' activities through different lenses—if regulators are only allowed to consider a few pre-determined measures when they decide whether banks are healthy or not, the banks will inevitably figure out a way to game those measures to disguise the risks they're taking.
      • Flexibility is very important in general—one of the reasons the subprime mortgage crisis was so bad was that banks had figured out a lot of ways to bend the rules of the regulatory system so they'd look less risky than they were, and regulators didn't have the flexibility to respond.
    • However, it can't be so intrusive that banks can't operate—if the banking system is over-regulated and can't make loans, the entire economy suffers

II. How did Dodd-Frank change financial regulation?

• After the subprime mortgage crisis of 2008, it was clear that the bank regulation system wasn't working, so the Dodd-Frank Wall Street Reform and Consumer Protection Act was created by Congress and the Obama administration to fix it.
  • The goal of Dodd-Frank was to strengthen financial regulation to keep the banking system from overheating and causing another crisis again, but not over-regulating it and impeding the recovery.

• The main elements of Dodd-Frank are:
  • The "Volcker Rule"
    • This bans banks from making most kinds of speculative investments.
  • "Too Big to Fail" oversight
    • Dodd-Frank gave regulators extra authority over "Systemically Important Financial Institutions" (SIFIs).
      • SIFIs are banks and other financial organizations (such as insurance companies) that are so big that their failure would affect the entire financial system—i.e., too big to fail.
  • Broader authority for regulators
    • Dodd-Frank broadened regulators' authority in several ways:
      • More authority over "shadow banks"
        • Before Dodd-Frank, many large financial entities escaped regulation because they weren't officially banks, such as large insurance companies (such as AIG), financial companies (such as GE Capital), and special subsidiaries that banks set up specifically to avoid regulation.
          • This is an example of the rule-bending that we talked about in Section I.
        • Many of these companies operated a lot like banks and got very big, but were less regulated; their excessive risk-taking was a major cause of the subprime mortgage crisis.
        • Dodd-Frank gave regulators much more authority over these entities.
      • Broader authority to liquidate failing banks
        • Dodd-Frank made it easier for the FDIC to liquidate insolvent banks.
        • It also gave the government authority to liquidate non-bank financial institutions.
        • Liquidation authority is very important because if insolvent financial institutions aren't liquidated it's very hard to recover from a financial crisis, but bank CEOs will never voluntarily liquidate (because liquidation puts them out of jobs).
          • The US has recovered from the subprime mortgage crisis more quickly than Europe in large part because US regulators recapitalized and liquidated banks much more quickly than European ones.
          • Japan never really liquidated its insolvent banks after its financial crisis in the 1990s and still hasn't recovered.
      • Authority over new financial products
        • Banks created a lot of new financial products in the boom years before the subprime mortgage crisis, and a lot of them weren't regulated because they were new.
        • These unregulated products played a large role in the financial crisis, and Dodd-Frank gave the government authority to regulate them
        • The most important of these new products was the Credit Default Swap (CDS).
        • CDS was basically credit insurance—if you owned CDS on a certain bond and the borrower defaulted on that bond, whoever you'd bought CDS from would reimburse you for the loss on that bond.
        • Many banks were on one end or the other of huge CDS trades; during the subprime mortgage crisis, no one knew whether the trades would be honored because they weren't regulated or even recorded centrally; this was a big contributor to the chaos of the crisis.
        • Dodd-Frank gave the government regulatory authority over CDS, and required that all CDS trades be processed centrally so there's a storehouse of information about the size of the trades and who's on each side of them.
      • Capacity for consumer protection
        • Dodd-Frank established the Consumer Financial Protection Bureau (CFPB), which is the first financial regulator that's specifically responsible for protecting consumers from predatory financial companies.
        • Since its establishment, the CFPB has taken aggressive action against many banks and other financial firms that have taken advantage of consumers.
          • To date, the CFPB has taken 150 enforcement actions and has won 146 of them, winning $11.8 billion in relief for consumers.
          • Targets have ranged from major banks and loan companies such as Wells Fargo and Navient to local pawnshops.
        • The CFPB is one of the biggest Republican targets.

• Many of these provisions of Dodd-Frank also broadened regulators' flexibility, which we know from Section I is very important.
  • For example, the Financial Stability Oversight Council, one of the new regulatory bodies created by Dodd-Frank, has a mandate to take a flexible approach to identifying and mitigating systemic risks to the financial system.
  • Republicans don't like this flexibility because they think it gives regulators too much power, but as we've seen, if regulators don't have flexibility it's very easy for banks to game the rules.

III. What is the Republican agenda to change Dodd-Frank, and why is it a problem?

• Dodd-Frank is similar to the ACA in that it's a complicated system that's not perfect, but has overall done its job pretty well.
  • Since it went into effect, there's been good growth in bank lending, but banks are still relatively well-capitalized and not taking excessive risks.
  • Dodd-Frank is also similar to the ACA because repealing it without a strong replacement system would be very irresponsible.
    • As we've seen, if banks aren't regulated they'll take excessive risks that will eventually lead to another crisis.
    • Reasonable people can disagree on whether the Dodd-Frank system is the best way to regulate banks, but if it's just repealed, we go straight back to the system that existed pre-2008 – and we'll get the same results.

• Trump's Treasury department just released the first of four proposals to modify Dodd-Frank, covering banks. Some of its main provisions are:
  • Raising the size threshold for banks to be covered by Dodd-Frank to $50 billion in assets (from $10 billion).
    • If this happened, only 42 of the roughly 5,000 banks in the US would be covered.
    • IndyMac, the largest bank to fail during the financial crisis, wouldn't have been covered.
    • While the 2008 financial crisis was mainly caused by big institutions, small institutions can threaten the financial system as well.
      • The Savings and Loan crisis of the late 1980s was caused by the failure of hundreds of small banks; it had almost as bad an effect on the US financial system as the 2008 crisis, and it took years for the economy to recover.
  • Weakening the Volcker Rule
    • Because a strong banking system is so important for the broader economy, banks shouldn't be taking high-risk speculative bets just to chase more profits.
    • Lehman Brothers and Bear Stearns failed in large part because of the size of their proprietary trading operations.
    • Repealing or weakening the Volcker Rule will make it easier for banks to creep into new, risky businesses that they don't understand.
  • Weakening the Consumer Financial Protection Bureau
    • There's a long history of banks and other financial institutions behaving dishonestly with consumers; we've seen this just recently in the Wells Fargo scandal.
    • The CFPB is the only agency that's responsible for protecting consumers from predatory financial institutions.
    • The Treasury proposal gives Congress more authority over the CFPB; given today's Congress, that's clearly intended to destroy the agency.
  • Weakening regulation of non-bank financial companies wasn't part of this proposal, but is expected to be in subsequent proposals.
    • Non-bank financial companies were some of the biggest contributors to the subprime mortgage crisis; AIG, an insurance company, received the biggest government bailout during the crisis.
    • The federal government needs the authority to regulate non-banks that are important to the financial system; repealing this part of Dodd-Frank would put these companies back in the Wild West.

• The Financial CHOICE Act (H.R. 10) passed the House in June; it represents the Republicans' attempt to take apart Dodd-Frank.
  • The Financial CHOICE Act, among other things, allows banks that maintain a 10% capital ratio (or buffer against losses for lenders and depositors) to be exempt from Dodd-Frank regulations.
    • Higher capital ratios aren't a terrible idea, but focusing completely on the capital ratio is a classic example of a rule that's very easy for banks to game. As we've seen, one-size-fits-all regulation is too simple to work in the complex modern financial system.
    • Also, capital ratios don't apply to non-banks, which clearly need to be regulated.

[1] Reinhart, Carmen, and Kenneth Rogoff (2009). This Time Is Different: Eight Centuries of Financial Folly. Part IV.

Questions or suggestions? Reach out to the RISE Stronger Economy & Jobs Working Group at [email protected]