This article is written by Kashish Khattar, a 4^th Year B.A., LL.B. (Hons.) student at Amity Law School in New Delhi. The article is a discussion about the Dodd-Frank Reforms, their effects and the recent rollback of certain provisions of the Dodd-Frank under the Trump Administration.

Introduction

The Dodd-Frank Act (or the Dodd-Frank Wall Street Reform and Consumer Protection Act) (“DFA”) is a United States Federal Law that places regulation of the financial industry in the hands of the government. This was passed under the Obama Administration in effect to the aftermath of the Great Recession of 2008. Named after U.S. Senator Christopher J. Dodd and U.S. Representative Barney Frank, the Act is expected to reduce various risks in the U.S. financial system. Enacted in July 2010, it creates financial regulatory processes to limit risk by enforcing transparency and accountability. The 2300 paged financial reform creates a number of new government agencies, like the Financial Stability Oversight Council and the Consumer Financial Protection Bureau etc.

Let us also try to understand the concept of “Too Big to Fail” institutions in the economy, the business has become so large and influences so many spheres of the economy that the government will have to step in and help bail it out of financial troubles. However, this kind of a bailout would only make sense to the government if the cost of bailout is less than the ripple effects that would be created if the business fails. The DFA is an action plan of the US Government to avoid Future Bailouts. A part of the act requires the financial institutions to create living wills explaining how they would liquidate assets if they have they have to file for bankruptcy.

Main Features of the DFA

Basically, this law puts strict regulations on lenders and banks in an effort to protect consumers and prevent the economy from an all-out recession. Dodd Frank creates several new agencies to oversee the regulatory process and implement certain changes. It has 16 major reforms ranging from the Insurance sector to the Corporate Governance sector. The main provisions are as following:

1. Consumer Safeguards – The Act creates a new Consumer Financial Protection Bureau (“CFPB”) under the Federal Reserve. The CFPB is responsible for consumer financial education, creating financial curriculum and making it available to the public. It is mainly made to protect the public from scams, and to ensure that quality services are being provided to the general public.
2. Volcker Rule –  Named after Paul Volcker, he was the chairman of the Federal Reserve under President Carter and President Reagan, and chairman of the Economic Recovery Advisory Board under President Obama. The Volcker Rule is clearly a push in the direction of the Glass-Steagall Act of 1933 which had recognized the dangers of the entities extending commercial and investment banking services at the same time. The Volcker Rule mainly prohibits the banks from making risky short-term trading of securities, derivatives and commodity futures for their own benefit and it also prohibits banks from investing in private equity and hedge funds from their own accounts. Further, it also prohibits banks from converting their charter to avoid enforcement actions by the authorities.
3. Federal Reserve Reforms – The DFA restricts the emergency lending authority of the Federal Reserve by the following provisions: a. Prohibiting lending to an individual; b. Prohibiting lending to insolvent firms; c. Requiring approval of lending by the Secretary of Treasury; and d. Requiring sufficient collateral for all and any loans protecting taxpayers from losses. Further, the DFA imposes greater transparency on the Federal Reserve by requiring it to disclose all terms and conditions of an emergency lending situation on a regular basis. The DFA also directs an audit of all emergency lending administered by the Reserve at the time of the Crisis of 2008.
4. Every bank who has more than $50 billion of assets must take an annual stress test given by the Federal Reserve, which will help determine if that institution can survive a financial crisis in the future.
5. The Financial Stability Oversight Council (“FSOC”) is created to mainly oversee banks and financial firms like hedge funds whose failure could impact the whole financial system of the country. The main goal of the FSOC is to build a better future and rule out the option of any future government bailout. It is typically an early warning system, which will identify the threats looming the economy and try to respond to them through various reforms. The FSOC reforms can range from (i) breaking up banks that are considered too large; (ii) reducing their lending and investing capacities to requiring banks to provide contingency plans for a quick; (iii) orderly wind up of their business if they become insolvent; and (iv) providing for restructuring of banking companies which are not doing so well.
6. The Consumer Financial Protection Bureau (CFPB) protects consumers from the corrupt business practices of banks. This agency works with bank regulators to stop risky lending and other practices that could hurt American consumers. It also oversees credit and debit agencies as well as certain payday and consumer loans.
7. The DFA also implements a series of mortgage reforms to protect the customers. The DFA has a provision which talks of regulating derivatives such as credit default swaps which are deemed to be the culprit in the recent financial crisis of the country. The problem with these credit default swaps is that they are traded over the counter, with little to no regulation. This makes it practically impossible to know what kind of a market do these swaps have and hard to predict the risks involved in this specific market. The DFA sets up a centralized exchange for swap trades to reduce the risky nature of the counterparty default and also requires greater disclosure of the information related to the trade.
8. The Office of Credit Ratings ensures that agencies provide reliable credit ratings to those they evaluate. The DFA established an SEC Office of Credit Ratings as credit rating agencies were accused of giving misleadingly favourable investment ratings which contributed to the financial crisis of 2008. The office now has the job of ensuring that agencies will improve the accuracy of their ratings and maintain a standard and reliable method in the credit ratings business.
9. A whistle-blowing provision in the law promotes any person to come up with information about violations to report it to the government for a financial reward. The DFA mainly expanded the existing whistleblower program promulgated by the Sarbanes-Oxley Act (SOX). This Act focused on (i)  establishing a mandatory bounty program where the whistleblowers can receive about 10-30% of the proceeds from a litigation settlement; (ii) broadened the scope of a covered employee by extending the ambit of definition of the employee and including employees of the company, its subsidiaries and affiliates; and (iii) extending the statute of limitation where a whistleblower can now bring forward a claim against his employer in 90-180 days after the discovery of such violation.

Critical Analysis

It is also believed that the act takes away the competitiveness of the US Firms relative to their foreign counterparts. The compliance requirements are huge even in the case of smaller financial institutions and banks even when they had no role to play in the 2008 crisis. The institutions may be safer, but the constraints made up by the DFA has made a more illiquid market. The reserve requirement as established by the DFA is high, which typically means banks have to keep a higher percentage of their assets in cash which in turn affects their investments in the marketable securities. The critics believed that the DFA will ultimately hurt economic growth. It is also said to be a highly expensive regulation because of the compliance burden and the new regulators it creates.

Was the Dodd-Frank Act successful?

The Dodd-Frank was unsuccessful in a lot of avenues. The banks are still believed to be gambling with the FDIC-insured money. There has been no change in casino speculation of the Wall Street banks. There is still no curb in derivatives trading, which was the key loophole which leads to the financial crisis. Nobody has gone to jail. There have been so many examples of criminal behaviour during the meltdown, but not one megabank executive has gone to jail. Reform of the credit rating agencies is still a long way home. Fannie Mae and Freddie Mac have not been fixed, even one can be sure that they had a part to play in the crisis. It has to be evaluated considering both the sides of the situation. The US economy needed a law like Dodd-Frank to be risk-averse towards the next financial crisis. It did make the Wall Street more cautious about taking risks. The Volcker rule for small banks was seen as a regulatory burden towards them.

Partial Roll Back of the DFA

On 24 May 2018, President Trump signed the Economic Growth, Regulatory Relief, and Consumer Protection Act (“Act”) into law which reforms a lot of provisions of the DFA. As a result, only 10 biggest US banks have to now comply with the DFA. The changes executed through this Act mostly affect the small banks and not the large banking institutions of the country. The changes can be explained under the following heads:

1. Exemption of Small Banks from the Volcker Rule: Banks with less than $10 billion in assets that have total trading assets and trading liabilities accounting for 5% or less of the total assets and affiliates of such banks will be exempted from the Volcker Rule, which would help decrease the compliance requirement put up on these banks. Further, the Act removes a Volcker Rule limitation that prohibits a bank-affiliated investment advisor from using its name on hedge funds and private equity funds.
2. Reduction of Regulatory Burdens for all banking institutions: The Act rules out the need for banking companies with less than $250 billion in assets to comply with most aspects of “enhanced prudential standards” as defined in the DFA. The limit defined by the DFA was $50 billion in assets which was deemed to be too low by the standards of too big to fail institutions.
3. The other features of the Act include easing up mortgage loan data reporting requirements for the majority of banks, add safeguards for student loan borrowers and also include credit reporting companies to provide free credit monitoring services.

What are the expected long-term implications of the partial roll back of the Dodd-Frank Act?

The long-term implications of such a massive rollback of the DFA is clear. The Congress took away the teeth of the regulation and left it to monitor just the 10-12 big Banking institutions of the United States. It relaxed rules for around 25 banking institutions of the 38 biggest banking institutions that control 1/6th of the assets of the United States. The law loosens up on a lot of regulations that are important for stability, such as living wills, enhanced capital requirements and the stress test. There are a couple of loopholes in the law which will primarily help the largest players in the sector and also U.S. subsidiaries of foreign banks in the way forward. The limit could have been around $75 billion to $125 billion, but the $250 billion mark can be seen as really aggressive. The popular opinion that the community banks will get a lot of relief is untrue, they have been quite unprofitable in the present times. Their disappearance can be attributed towards their consolidation in medium or lower sized banks. The law dilutes most of the stringent regulations imposed, it makes things simpler for small and medium U.S. banks. It basically makes them more profitable and eases regulations for them to do business. The law only regulates bank which has assets amounting to $250 billion or more. The long-term implications can be dangerous because the banks with assets between $50 billion to $250 billion had a role to play in the crisis of 2008, as stated by the communications director of a non-profit coalition of organisations advocating for financial regulation. At the moment, it is too soon to figure out the long-term implications of this roll back can benefit the customers.

China’s very own Dodd-Frank

The Chinese regulators have introduced a new major regulation which is being termed as Beijing’s Dodd-Frank Act. This Act mainly tries to limit the shadow banking activities in light of President Xi Jinping’s call to reduce financial risks in the country. It is expected that around $15 Trillion or 100 trillion yuan will fall under the purview of this regulation. The regulation has been jointly drafted by the People’s Bank of China and China’s banking, securities and insurance regulators. The new regulations are a ministerial-level set of rules but they are expected to have a lasting impact on China’s financial world, drawing a parallel to the Dodd-Frank Act and its impact on the US Economy.

The draft legislation can put an end to China’s extraordinary financial market by restricting what the financial institutions can offer and what all can be bought by the investor in this market. A qualified investor is expected to have 5 mn yuan in family financial assets or should have earned more than 400,000 yuan a year for three consecutive years. The financial institutions will not any promises on returns and have to set aside 10% of their fee as risk reserves. The regulations are mainly expected to affect wealth management products which are offered online. The new rules aim to handle excessive leveraging in China’s non-financial banking sector with individual leverage limits to be set on asset management products. The rules are expected to cap the total assets to net assets ratio to 140% for mutual funds and 200% for private funds.

India’s take on the Dodd-Frank reforms

RBI decided to adopt the global best practices related to banking and came up with their own Framework for Dealing with Domestic Systemically Important Banks. (“D-SIBs”). There are only three banks that have been listed under this category. They are SBI, ICICI Bank and the HDFC Bank. SIBs are basically perceived as banks that are ‘Too Big to Fail’. This creates an expectation of government support at the time of distress. India, at present, has 3 too big to fails banks, they are mainly subject to a greater scrutiny than their peers and will always need to set aside a higher capital because the inclusion in this kind of a list gives them a premium status with regard to the other banks. It is perceived that these banks have direct support from the regulator and the government. Typically, the government will always throw them a lifeboat if ever such a need arises. There is enough evidence that the RBI and the Government never allow a bank to wind down irrespective of the hardships it is facing. The most recent example can be the Recapitalisation of Public Sector banks by the government. The government has already started thinking of consolidation of public sector banks, it is expected that despite these banks being hit by bad loans the lenders will be merged instead of being wound down.

Conclusion

The financial crisis was mainly due to the low regulation and trusting the large firm’s banks in the country who were too big to fail. The Dodd-Frank Wall Street Reform Act was the most comprehensive financial reform since the Glass-Steagall Act. The main objective of the Dodd-Frank Act was to regulate these large banks and firms who could have a major impact on the economy in a more stringent manner. President Trump approach towards easing the regulation of the DFA was clear, he will do whatever the business wants. He was a supporter of the real economy, which built things. President Trump had promised in his campaign trail, the revival of the Glass-Steagall Rule which separates investment banking from commercial banking. Nothing has been done of the sort, till now. The DFA roll back also concentrated on the provisions regarding the small banks and nothing which relates to the big banking institutions of the country.

Quoting from a Vox Article – “And the nature of bank regulation is that even when it’s done really, really poorly, the odds are overwhelming that on any given day, nothing bad is going to happen. As long as the economy is growing and asset prices are generally rising, a poorly supervised banking sector is just as good as a well-supervised one. But when the music stops, and it always does, a poorly supervised banking sector can turn into a huge disaster. It’s only a question of when.”

Only the time will tell, how this presidency will reform the banking regulation to make it more resilient towards a financial crisis.