What is the Dodd-Frank Act?

This law follows the disastrous consequences of the 2007-2008 financial crisis, which was caused, in part, by the default on subprime mortgages (of the real state sector). The law aims at preventing the same circumstances that caused the crisis from happening, or, at least, minimize the effect of those circumstances.

One of the main topics about the financial crisis was that the doctrine “too big to fail” proved to be false, since the crisis started with the collapse of Lehman Brothers bank, which was one of the biggest banks in the US. Beyond that, the intense use of securitization techniques was a big issue, because low-risk mortgages were mixed with high-risk mortgages, for later selling these new financial instruments while keeping a low-risk label. This dangerous process was possible because the new instruments were backed by some type of default insurance.

This shouldn’t had been a big problem, but the loose regulations on lending and the US laws whose existence was determined to encourage low-income Americans to buy properties (thus, get a mortgage) created a huge quantity of high-risk mortgages (high default probability).

Finally, many of those new instruments were sold under the protection of the US federal government, which created a moral hazard for the banks.

In 2009, President Obama tried to make a proposal for regulating the financial and banking sector, which finally took effect in 2010. Some of the measures of the law didn’t take effect until late 2015.

The main point of the law is to control banks’ financial connections in the financial system and “too big to fail” banks, in general. Also, hedge funds came under supervision.

Banks were also required to have plans for insolvency/bankruptcy situations, so the lessen the contagion risk.

In order to achieve the optimal level of control, the law created a new institution, called the FSOC (Financial Stability Oversight Council), administered by the Federal Reserve (FED), the Consumer Financial Protection Bureau (CFPB) and the Securities and Exchange Commission (SEC). If the council considers that a bank has become too big, they could ask the FED to increase the reserve requirement for that specific bank.

Another important tool was the “Volcker Rule”, by which banks aren’t allowed to use or own hedge funds for their own profit, nor using clients’ deposits to make transactions for the bank’s profit.

It also regulated the riskiest derivatives, making them to be regulated by the SEC. Finally, it also obliged credit rating agencies to be overseen by the Office of Credit Ratings, ruled by the SEC.

The application of the law has been modified by President Trump in 2018, with the goal of helping community banks and lending institutions. This has been achieved by exempting some small and medium banks from the law’s regulations.