In the wake of the 2008 financial crisis, the lack of regulations in the banking industry was abundantly clear. As a result of loose-lending, nearly 8 million homes in the U.S were forced into foreclosure and its repercussions were felt in almost every facet of society. In the hopes of preventing another financial meltdown, the Obama administration created the Dodd-Frank Act. Its goal was to reign in some of the finance industry’s riskiest practices.
What is the Dodd-Frank Act
In the months leading up to the financial crisis, banks and lending institutions would create loans and sell them to third parties. These parties would in turn sell securities to investors backed by these loans from the bank. However, the institution making the loan did not bear any risk and hence had no incentive to ensure if the loan was actually good. The lack of credit tied to these loans resulted in the housing bubble burst and pushed the economy into a recession.
The eponymous Dodd-Frank was co-sponsored by Sen. Christopher Dodd and Rep. Barney Frank. Its aim was to better regulate the financial industry and prevent a financial crisis like the one in 2008. This was achieved by adding more mechanisms along with greater checks and balances on the lending institutions. The government was also given the authority to regulate the finance industry and enforce laws on the banks as required.
One of the most important mandates in the Dodd-Frank Act was the Volcker Rule named after the chairman of the Federal Reserve. It regulated the way banks used their own money to invest in stocks and securities, a practice that is commonly referred to as proprietary trading. Banks are also restricted from owning hedge funds or private equity funds under this rule.
Less risk: more skin in the game
Numerous reforms were created to ensure that the financial infrastructure of banks was more transparent and navigable. Here are three ways the Dodd-Frank Act made commercial loans less risky.
1.Greater bank equity
While banks are legally obligated to pay back the money owed to depositors and bondholders, the same does not apply for holders of common stock. The risk associated with this stock is solely on the shareholders. This stock is referred to as ‘loss-absorbing’ since the bank is not contractually obligated to pay back the money. The bigger the equity, the larger the cushion for banks to bear losses.
Before the Dodd-Frank Act, banks operated on a low loss to equity ratio such as 44:1. This means that for every $44 in assets only $1 was able to absorb losses. This financial cushion was not large enough to prevent banks from going under. Under the Dodd-Frank Act banks need to maintain a 5% equity on assets and a ratio of 20:1. The government can require a higher leverage ratio for riskier assets.
2. Stress test
The Dodd-Frank Act required assurance that the banks will be able to survive future crashes or recessions without a bailout from the government. To combat this issue, the stress-test was created. This is where a stimulation of the 2008 crash is done to see if banks are able to walk away scot-free without government support at their current level of operations. The test is done by the 30 largest banks in the U.S followed by an examination of the balance sheet. If banks fail the test, the government will place regulations to strengthen their balance sheet numbers.
3. The FSOC
Prior to the Dodd-Frank Act various councils were put in charge of regulating banking practices. This meant that there was no consolidated overview of the financial system and no dots to connect the different pieces.
The Dodd-Frank Act created the Financial Stability Oversight Council (FSOC) which is a single entity responsible for assessing risks in the financial system. They brought regulators together to better understand the big picture and identify if certain elements could cause systemic harm to the industry. This allows them to take action before the lack of oversight falls between the cracks.
Changes to the Dodd-Frank Act
Under the new administration, a number of changes have been made to ease the regulations under the Dodd-Frank Act. Banks now have to undergo lower federal oversight, making it easier for them to operate. Only the top 10 banks need to abide by strict regulations while small and mid-size banks are free to function as they see fit.
In addition to this, many banks are no longer required to take the stress test to examine their survival rate in the event of a downturn. The Home Mortgage Disclosure Act that was passed under the Dodd-Frank Act is no longer applicable to numerous loan companies. Further changes may be made to the Dodd-Frank Act in the upcoming months such as the easing of regulations under the Volcker Rule.
The bottom line
The Dodd-Frank act is not a fix-all solution for the discrepancies in the financial industry however it does provide a framework for making more informed decisions when regulating institutions. Authorities are now able to have discussions on the successes and shortcomings of the banking industry, placing them in a better position to prevent another financial meltdown.