The Implications Of The Dodd Frank Act Finance Essay
In response to the recession of the late 2000’s congress called for a sweeping change in American financial regulation. H.R. 4173, the Dodd Frank Wall Street Reform and Consumer Protection Act was signed into law on 21 July 2010. The Act calls for a number of reforms that will have an impact on banking regulation in the future. This paper will analyze some of the likely effects of the Dodd Frank Act on banking.
The Act calls for an end to the “too big to fail” philosophy. It ends the possibility that taxpayers will be asked to bail out financial firms and calls for creating a safe way to liquidate failed firms. It imposes tough requirements that make it undesirable for an institution to become excessively large. Ending too big to fail will have substantial impacts on large banks. These banks will no longer have a government safety net. With failure as a possibility, they will have less incentive to engage in risky enterprises. Engaging in these risky endeavors got them into trouble to begin with and led to a global recession. The mere existence of a bank that is too large to fail makes that bank more attractive to investors because of the very low risk involved. As more investment is made in the bank it becomes even larger creating an even bigger problem if it fails. With no chance for a bailout investors will be less inclined to invest in mega banks. Section 172 requires higher capital requirements on banks as a means to cushion against other failing banks and as a way to prevent banks from overinvesting in risky endeavors. The new regulations should moderate the size of banks and prevent them from becoming too large to begin with.
The Act will also require banks to retain some of the risk involved with asset backed securities excluding high quality mortgages. [i] This should put a stop to the free lending attitude of banks. Previously they made as many loans as possible bundled them up and sold them as securities without proper underwriting. Now however, banks will be required to keep some “skin in the game”. The Dodd Frank Act requires whoever securitizes a group of loans to retain no less than five percent of the credit risk for any asset backed security they sell.” This should give institutions some incentive to practice good underwriting and limit the amount of risky loans they make. Five percent is not much but it is the minimum required and the actual figures and rules have yet to be implemented. Requiring banks to retain more than five percent would significantly reduce the amount of questionable loans and ensure good underwriting procedures are followed. Accurate underwriting will give investors an accurate idea of the risk involved in the asset backed securities they purchase and allow them to more efficiently manage their investments.
The Dodd Frank Act also created two new watchdog entities. The Consumer Financial Protection Bureau was created to protect and enforce consumer law and ensures that services are fair transparent and competitive and the Financial Stability Oversight Council whose main purpose is to identify and respond to risks to the financial system. [ii] The CFPB strives to promote financial education, enforce consumer law, and analyze information to better understand the financial markets. Their purpose is essentially to assist consumers in making better financial choices. Consumer ignorance and a lack of financial transparency were huge factors in causing the recession. As long as this new government organization does what it claims consumers will be better equipped to handle their financial matters. The CFPB will have the ability to enforce and regulate banks, and credit unions with more than ten billion dollars in assets, mortgage related businesses, payday lenders, student lenders, and more. This broad jurisdiction should prevent consumer exploitation through hidden fees, exorbitant terms, and any other financial malfeasance. The FSOC will over watch the financial system as a whole and provide an early warning system to detect practices that can cause system wide instability. The FSOC will be able to regulate institutions through various means including creating capital standards and breaking up large companies. The FSOC will use these powers to prevent institution from becoming too big to fail in the first place and should prevent them from causing systematic risks by other means. These agencies have the opportunity to establish industry wide stability. As long as they are allowed to work within their mandates they should prevent some of the situations that took us into a recession.
One of the more interesting provisions in the Dodd Frank Act comes from section 922, also known as the whistleblower provision. Under this section the SEC is authorized to pay whistle blowers up to 30% of the financial penalties collected from a whistleblower’s report providing that the sanctions exceed one million dollars. This rule gives an incentive for workers within an organization to report financial incongruities. The people who work directly for a bank or financial institutions are the best sources of this kind of information. This provision provides the SEC valuable information that it might otherwise miss and makes the employees in financial institutions quasi regulators. The whistleblower provision will make financial institutions think twice before they attempt to defraud investors and the government. It will promote accountability in both the monetary and moral sense.
Under the Dodd Frank Act hedge funds will also be subject to SEC scrutiny. Each hedge fund will be required to register with the SEC and be subject to periodic audits. Title IV requires these independent financial intermediaries to report on many of their financial activities. These hedge funds are not keen on revealing their information to government organizations but they have little choice. With more transparency and the powers entrusted to the FSOC large, risky hedge funds will become targets for the government. We should see significant intervention into these entities by the FSOC under the guise of preventing another financial crisis. Before the Dodd Frank Act these institutions were mostly unregulated and they caused systematic problems due to the scale of risk they undertook. Preventing a system wide melt down is one of the main goals of the Dodd Frank Act. Regulating hedge funds and other independent financial intermediaries is a crucial part meeting that goal.
Along with hedge funds, credit rating institutions are facing some new rules. First, the SEC will have the power to deregister credit rating agencies that provide consistently bad or misleading credit ratings. Inaccurate ratings by these agencies had a huge impact on asset backed securities making them seem less risky than they were. The threat of deregistration by the SEC should keep these agencies providing accurate ratings. Credit rating agencies will now also be subject to “expert liability”. Investors will be able to hold accountable any agency that knowingly provides inaccurate readings and holds the credit rating agencies responsible for obtaining the facts about whatever it is they are rating.
Excessive lending and overall carelessness pushed the global economy to its limits. The Dodd Frank Act seeks to prevent similar circumstances in the future. Banks and other financial institutions were not adequately regulated after the Gramm-Leach-Bliley Act repealed many of the measures set in place to protect the economy by the Glass-Steagall Act. The actual rules and regulations are still to be written by the organizations that will be enforcing them. Only the framework for the actual rules exists. However from analyzing The Dodd Frank Act we get a general idea of how banking regulation will be affected in the future. More regulation of financial institutions will bring more stability and hopefully prevent any new financial meltdown.
Need an essay? You can buy essay help from us today!