What 2008 events gave rise to the need for this legislation?
The need for the Dodd-Frank Act (which complete name is the “Dodd–Frank Wall Street Reform and Consumer Protection Act”) was given rise by the financial crisis of 2007–08. This crisis triggered the Great Recession, an event many economists consider the worst crisis in the financial markets since the 1930’s (Dodd-Frank Financial Regulatory Reform Bill Definition, 2016).
The United States had suffered a “housing bubble” – an unexpected and sharp increase in real estate prices, fueled by easy credit, that lasted over a decade – which had burst in 2004. Many traded financial instruments had their value directly or indirectly linked to the real estate market, and the “bursting” of the bubble caused their price to plummet. This event had a harmful effect to financial institutions, which became much more fragile afterwards, as they were unsure about the value of their assets linked to housing market. In other words, the main clients of banks and other financial institution were afraid that they would not be solvent.
This solvency issue was in part due to increasing deregulation in years prior to 2008. When the housing bubble reached its peak expansion and sudden crash, the destruction of asset value displayed that banks and insurance companies lacked enough capital holdings to fund their previously made commitments. Because of this increasing doubt, and to avoid a generalized bank rush, in March 2008 the federal government rescued the investment bank Bear Sterns. In September 2008, however, the government decided to let Lehman Brothers fail – the morning after such measure, the worldwide markets plummeted and a de facto bank rush started. Immediately, reassuring monetary and fiscal policies were enacted, as Central Banks in the whole world injected money in the economy, whereas governments decreased the tax burden and increased spending. These measures allowed for the economy to stay afloat – despite a sharp recession in the years after, there was no depression – but were was faced with sharp resentment of the public opinion, which pressured the Congress into action.
The U.S. Senate's Levin–Coburn Report came to the conclusion that the crisis had been the outcome of issues such as: high risk lending; regulatory failures; inflated credit ratings; and the misbehavior of investment banks doing structured finance. (Senate Investigations Subcommittee Releases Levin-Coburn Report On the Financial Crisis, 2016). Congress responded to that with the enactment of the Dodd-Frank Act, a new legislation that attempted to address these issues.
What are the key provisions of this legislation?
U.S. President Barack Obama proposed in June 2009 a new legislation that would overhaul the American regulatory system of the financial industry (Dodd-Frank Financial Regulatory Reform Bill Definition, 2016). After a long discussion in Congress, the Dodd-Frank Act became law on July 21, 2010. Its main provisions include:
The amalgamation of financial regulatory agencies and the creation of an oversight council, which main activity is to evaluate systemic risk.
Extensive and new regulation of financial markets, to increase transparency of transactions. This included bringing derivatives to the exchanges’ floor (“hidden” derivatives were a major issue that triggered the financial crisis of 2007-08)
New consumer protection legislation and the creation of a consumer protection agency.
The standardization of "plain vanilla" banking products, accompanied by enhanced protection to investors.
A “legislative toolbox” to enable for a quicker response to financial crisis. Such legislation allows for government agencies to systematically wind down bankrupt firms. It also gives the Federal Reserve greater flexibility to extend credit during financial turmoil.
A number of measures to improve international reporting accounting standards and cooperation. Moreover, the law tightens regulation of credit rating agencies – these institutions had failed at properly rating the score credit of many financial products and institutions prior to the 2007-08 financial crisis.
The “Volcker Rule”, a reference to former Fed Chairman Paul Volcker, which restricted banks from making some speculative investments that were deemed not beneficial to their customers. This was supposed to be a broad ban on trading by commercial banks, but the final version of the act provides for a number of exceptions.
Do you think this legislation, once implemented, will be effective in preventing a repeat of the 2008 events?
In my opinion, it is unlikely that this legislation will be very effective preventing financial crisis such as the one that happened in 2007-08.
The first issue I would like to raise is exemplified the enactment of the “Volcker Rule”. The original intention expressed by the former Chairman of the Fed was to propose a “lightweight Glass-Steagall” provision, that sharply separated the investment banking and the commercial banking industries for nearly 80 years in the United States. The dismantling of the Glass-Steagall act had been pointed out as one of the factors that contributed to the crisis that led to the Great Recession. The final version of the Volcker Rule allows for too many exceptions – unlike the original Glass-Steagall Act – and banks can work around the definition of proprietary trading. The main reason for the enactment of this weak provision is probably linked to bank lobbying in Congress, but those things are hard to prove. Ultimately, all we can tell is that banks were benefited by the enactment of the Volcker Rule as it currently stands, and the same statement could not be have been said about the Glass-Steagall Act.
Second, the creation of a single, unified oversight agency is risky. Such agencies always suffer from the danger of being coopted by the regulated entities. Maybe a greater number of agencies, with overlapping tasks and diverse teams, could be harder to coopt than a single big agency.
My third objection has to do with the supposed attempts to “improve international reporting accounting standards and cooperation.” The United States has, since the enactment of this legislation, shied away from International Repporting Accounting Standards (IFRS) and favored the U.S. Generally Accepted Accounting Principles (U.S. GAAP). Such preference shows a dire future for the standardization of accounting standards, as the U.S. actually opens the door to other countries to imitate its behavior and fail to adopt IFRS as well.
Because of the list of reasons above, that is, the weakness of the Volcker Rule (particularly when compared to the Glass-Steagall Act), the possible cooption of a unified regulatory body, and the failure to follow IFRS, I believe that the Frank-Dodd Act is riddled with loopholes and backdoors. Such flaws will allow regulated bodies (banks, insurance companies, and other financial institutions) to effectively escape the main tenets of the law. Therefore, I am of the opinion that it is unlikely that this new law will be effective in preventing future financial crisis.
Works Cited
"Dodd-Frank Financial Regulatory Reform Bill Definition." Investopedia.
N.p., 2010. Web. 04 May 2016.
"Senate Investigations Subcommittee Releases Levin-Coburn Report On the Financial
Crisis." Majority Media | Media | Homeland Security & Governmental Affairs
Committee. N.p., 13 Apr. 2011. Web. 04 May 2016.
