The Dodd-Frank Act
from Renewing America

The Dodd-Frank Act

President Barack Obama congratulates Senator Chris Dodd and Representative Barney Frank after signing the Dodd-Frank Act in 2010.
President Barack Obama congratulates Senator Chris Dodd and Representative Barney Frank after signing the Dodd-Frank Act in 2010. (Jim Young/Reuters)

The Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank"), signed into law in July 2010, is one of the most significant regulatory reform measures since the Great Depression.

Last updated December 10, 2013 7:00 am (EST)

President Barack Obama congratulates Senator Chris Dodd and Representative Barney Frank after signing the Dodd-Frank Act in 2010.
President Barack Obama congratulates Senator Chris Dodd and Representative Barney Frank after signing the Dodd-Frank Act in 2010. (Jim Young/Reuters)
Current political and economic issues succinctly explained.


The Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank"), signed into law in July 2010, is one of the most significant regulatory reform measures since the Great Depression. Proponents contend its major provisions—monitoring systemic risk, limiting bank proprietary trading (the "Volcker rule"), placing new regulations on derivatives, and protecting consumers—will help prevent another financial crisis. Detractors, including many Republicans and Wall Street executives, argue that the reforms will imperil future economic growth by over-constraining the financial system.

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After three years, the implementation of Dodd-Frank has been partial, with many delays. In late 2013, regulatory experts estimated that only 40 percent of Dodd-Frank’s roughly four hundred provisions were finalized. However, federal regulators’ approval of the Volcker rule in December marked a substantial step forward. Meanwhile, debate continues over Dodd-Frank’s potential effectiveness. Republican lawmakers have introduced bills to amend or repeal the act, and to curb funding of financial regulatory agencies. Others suggest the law does not go far enough in addressing central issues such as banks that are "too big to fail" (TBTF) and the associated moral hazard.

Brief History of U.S. Financial Regulation

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The Wall Street crash of 1929 popped the stock bubble inflated by the trading frenzy of the roaring twenties. The ensuing financial panic weakened many banks that had speculated in the stock market, and their failures accelerated the Great Depression [PDF]. President Franklin D. Roosevelt’s New Deal introduced legislation to prevent and limit the scope of future financial panics.

The Banking Act of 1933 ("Glass-Steagall") established the Federal Deposit Insurance Corporation (FDIC) and several regulations, including preventing deposit-taking commercial banks from speculating on stocks. In 1934 the Securities and Exchange Commission (SEC) was created to regulate securities trading. But Glass-Steagall restrictions began to erode in the 1960s, until finally President Bill Clinton signed the Gramm-Leach-Bliley Act of 1999, which erased the barrier between commercial banks and investment banks.

Volcker reasoned that financial firms backed by government deposit insurance should not be permitted to speculate.

Financial innovation continued to move derivatives beyond their roots in agricultural futures, and the regulatory status of several types of derivatives was uncertain. The Commodity Futures Modernization Act of 2000 explicitly stated that most "over-the-counter" (OTC) derivatives would not be regulated at the contract level, though dealers could be subject to firm level regulations. Banks tended to prefer OTCs to derivatives traded on exchanges such as the Chicago Board of Trade; OTCs could be customized to fit client needs, and they were often more profitable because competition was less perfect and prices were more opaque.

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In the wake of the global financial crisis and recession that began in 2007, attention turned toward perceived regulatory failures to restrain excessive risk taking and questionable practices. On July 21, 2010, Dodd-Frank was enacted.

Financial Stability Oversight Council and Orderly Liquidation Authority

Dodd-Frank established the Financial Stability Oversight Council (FSOC) to address systemic risks in the U.S. financial system and improve coordination among financial regulators. A systemic risk exists when the failure of one firm may topple others and destabilize the entire financial system. The firm is "too big to fail," or perhaps more accurately, "too interconnected to fail."

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The FSOC can flag financial firms—including non-banks—that pose such risks for stricter oversight by the Fed, including the imposition of short-term debt limits, risk-based capital requirements that include off-balance sheet activities, annual stress tests, and a 15-to-1 leverage limit.

All financial institutions must submit living wills that outline their credit exposure and plans for an orderly dismantling in the event of financial distress. Living wills are designed to avert a repeat of the type of failure at Lehman Brothers and Bear Stearns. At the time, there was no orderly process, just a choice between a messy liquidation and a taxpayer-supported bailout or merger. The Dodd-Frank Act established a procedure for restructuring or liquidating failing financial firms that would pose a danger to the U.S. financial system [PDF] if traditional bankruptcy was pursued.

Orderly liquidation authority was granted to regulators to deal with the failure of large, complex financial institutions. It is modeled on the FDIC process that successfully took deposit-taking banks like Washington Mutual that failed during the crisis into receivership and restructured them without significant disruption to the broader financial system.

While the FDIC is also in charge of this process, creditors and shareholders will bear all losses, and management will not be retained in whatever firm emerges from restructuring. Finally, no taxpayer funds can be used to prevent liquidation.

Simon Johnson, former chief economist of the International Monetary Fund, argued that the FSOC has done little to limit the growth of TBTF banks and suggests revising capital requirements for giant institutions and breaking up large banks, though he praised the choice of FDIC as receiver. Stephen Lubben also explains flaws he sees in the liquidation process.

The Volcker Rule

While the Glass-Steagall Act had barred deposit-taking banks from conducting proprietary trading, its repeal with the Gramm-Leach-Bliley Act (1999) led to rapid growth in trading by major banks. In the wake of the financial crisis, former Fed chairman Paul Volcker proposed banning proprietary trading by these banks, reasoning that financial firms backed by government deposit insurance should not be permitted to trade speculatively for their own benefit.

The original hope was to complete the Volcker rule by the end of 2012 and give banks eighteen months to prepare for implementation. However, bureaucratic hurdles delayed finalization and approval of the rule until December 2013. Federal regulators have given Wall Street until July 2015 to fully comply.

But there is still much debate over the Volcker rule, and some analysts expect banks to wage a legal battle in the months ahead. Some critics argue it is not strong enough and contains potential loopholes. For instance, many speculate whether banks might be able to disguise taking their own speculative positions as market-making for clients or as the hedging of risk, which are still permitted under the regulation. The Volcker rule includes measures and formulas that will attempt to discern whether trades are proprietary, but it’s unclear whether these will be sufficient.

Opponents of the rule say it will prevent banks from performing important business functions and would not have prevented the financial crisis. For instance, it would not have affected financial institutions that do not take deposits, such as Bear Stearns, Lehman Brothers and AIG.

Financial regulators say the Volcker rule’s utility will hinge on how it’s implemented. "The ultimate effectiveness of the rule will depend importantly on supervisors, who will need to find the appropriate balance while providing feedback to the board on how the rule works in practice," said Federal Reserve Chairman Ben Bernanke in December 2013.

Consumer Financial Protection Bureau

Many analysts cite the predatory lending practices of major home lenders, such as Countrywide Financial (purchased by Bank of America in 2008), as a contributing factor to the financial crisis. Countrywide, the country’s largest home lender, was sued by several states in 2008 for predatory practices. As a settlement the company agreed to provide $8.4 billion in loan relief to some 400,000 borrowers. The Consumer Financial Protection Bureau (CFPB) was created to help prevent such industry abuses and to integrate federal regulations protecting individual consumers into one agency.

Elizabeth Warren, then a special advisor instrumental in the bureau’s formation, explained in House testimony that CFPB’s overall goal was "making markets for consumer financial products and services work in a fair, transparent, and competitive manner." She also listed the bureau’s priorities as follows: mortgages, credit cards, financial education, consumer complaints, information technology, and supervision, enforcement, and fair lending.

The CFPB has drawn substantial criticism from Republican lawmakers, some of whom helped delay the Senate confirmation process of Warren and then Richard Cordray for director. GOP criticism largely centered on CFPB’s powers; Sen. Richard Shelby (R-AL) said the bureau’s director had "unprecedented authority over the American people without any checks."

Warren won the Massachusetts Senate seat in November 2011, and sits on that body’s Banking Committee. Cordray was confirmed by the Senate after a lengthy confirmation battle in July 2013. Meanwhile, the broadness of CFPB’s powers has been challenged by banking groups in court, and Republican lawmakers have introduced bills to eliminate CFPB or curtail its funding.

Regulation of Derivatives

Derivatives are financial instruments that allow two parties to enter into a contract based upon the price of something, without either having to actually own that something. While derivatives can be used to hedge risks, they can also be used to speculate. In 2003, Warren Buffett described them as "financial weapons of mass destruction." The 2008 failure of Lehman Brothers and the near failure of American International Group (AIG) threatened other banks with great losses. The widespread use of derivatives raised uncertainty in financial markets as banks struggled to understand the ultimate value of contracts with distressed firms.

AIG had become a market leader in selling credit default swaps (CDS)—a derivative that pays if the firm it is issued for fails. AIG had written its CDSs as OTC derivatives. The OTC market was opaque and lucrative to dealers, but since the CDS market was so large, an AIG failure could have deepened the crisis.

Dodd-Frank brought new regulations to the OTC derivatives market. Financial firms must use derivatives clearinghouses, where traders post capital once a contract is open to cover potential losses, thus limiting the bets a firm can make. These requirements are higher for firms with larger positions that may pose a greater systemic risk.

The act also mandates that most derivatives that go through a clearinghouse must be traded through a regulated exchange or on a trading platform that meets specific requirements. This adds transparency to pricing. Rather than discussing the price with one dealer, a trader can see the market rate for a particular contract.

Non-financial firms that use derivatives to hedge business risks—like an airline that buys oil swaps to limit its exposure to fluctuating prices—are typically exempt from the above regulations. While the derivatives industry has stated it supports the broad aims of Dodd-Frank, it has lobbied against specific rules. For instance, in June 2012, derivatives players pushed back against a rule proposed by the CFTC to protect price discovery by requiring that exchanges only list derivatives for which more than 85 percent of trading volume is on the exchange. As of September 2013, the CFTC has finalized sixty-one rules, but has issued proposals on another sixty-eight rules.

Effect on U.S. Competitiveness

Dodd-Frank’s new regulatory authority extends to the overseas operations of domestic banks. JPMorgan Chase CEO Jamie Dimon testified that this may hurt his firm competitively. "If JPMorgan overseas operates under different rules than our foreign competitors, we can no longer provide the best products and services to our U.S. clients or our foreign clients," he said.

There was a lot of rhetoric in the wake of Lehman about coordinating financial reregulation, but it hasn't materialized.
Benn Steil, Council on Foreign Relations

Both former Treasury secretary Timothy Geithner and a commissioner of the CFTC warned of the potential for financial firms to take advantage of different derivatives regulations if rules are inconsistent. The G20 continues to support the Financial Stability Board and implementation of the Basel III accords on banking capital. While U.S. regulatory officials are optimistic about achieving shared goals, they often acknowledge that individual countries will often tailor standards [PDF] rather than adopt a completely international framework.

CFR Senior Fellow and Director of International Economics Benn Steil is pessimistic on the extent of international cooperation: "International collaboration has never been all that great. There was a lot of rhetoric in the wake of the Lehman Brothers collapse about coordinating financial reregulation—at least on a transatlantic basis—but it hasn’t materialized in any significant form. There are very disjointed efforts."

Alternative Reforms

Republicans opposed to Dodd-Frank believe it would impede economic growth due to the cost and complexity of implementation, the possibility of reducing access to capital and credit, and by failing to eliminate TBTF.

In the fall of 2008, CFR convened the Squam Lake Working Group on Financial Regulation (SLG). Dodd-Frank included several variations of the Squam Lake proposals—a systemic regulator for financial markets [PDF] using exchanges and clearinghouses for derivatives, improved resolution options, etc.—but not all.

The University of Chicago’s Anil Kashyap said that Dodd-Frank had failed to address important factors in the financial crisis: "The general problem that we had runs in many forms (asset backed commercial paper, prime brokerage, OTC derivatives, repo, money market mutual funds) and Dodd-Frank did nothing to deal with most of this. Stronger capital and liquidity rules are the best way to deal with this problem, but the response needs to be customized for the different markets."

In an April 2012 Policy Innovation Memorandum, CFR’s Benn Steil provided an alternative to the Volcker rule: hard limits on total bank assets and reducing the tax incentive of debt financing. He also said that the government has shown a willingness to extend its support during times of crisis, a tendency that undermines the ability of Dodd-Frank to end TBTF. Even former FDIC Chairman Shelia Bair, a Dodd-Frank supporter, said, "We don’t really end TBTF until we convince the market that they are going to take losses if these big banks get into trouble."



In this documentary series, PBS Frontline tells the inside story of the global financial crisis.

William Alden of the New York Times provides a succinct history of the war of words over the Volcker rule.

This Backgrounder examines the role of the U.S. Federal Reserve.

This 2008 report from the Brookings Institution explores the U.S. origins of the financial crisis.

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