Five years ago, in the aftermath of the housing crisis and the subsequent Great Recession, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act. The document, which runs more than 2,000 pages, arguably represented the most sweeping overhaul of the US financial system since the Great Depression.
Among its ambitious goals, Dodd-Frank aimed to prevent taxpayers from being forced to bail out banks that were "too big to fail," regulate riskier investments such as derivatives and properly represent existing investment risks, force banks to keep a larger amount of emergency capital on hand, and protect consumers from fraudulent or predatory financial practices. Has it worked as planned? A full answer is years away. Approximately 60%-70% of the Dodd-Frank regulations have taken effect to date, with others scattered from proposal through draft stages.
It's not surprising that the process is taking time. According to the Mercatus Center at George Mason University, Dodd-Frank is associated with 27,669 restrictions — over 2,000 more than the collective restrictions of all other laws passed in the Obama administration through 2014.
Let's start by looking at loans. Lending practices were heavily scrutinized under Dodd-Frank and more mortgage risk was directed toward banks with the threat of being forced to buy back defaulted high-risk loans. Credit tightened as banks became risk-averse, making it difficult for all but the lowest-risk borrowers to get mortgage loans.
In this realm, Dodd-Frank has been effective but may have gone too far in the balance between risk and credit availability. Risk was reduced, but the housing recovery has been stunted as a result and lower-income families have been mostly shut out of the market. Recall that the problem with mortgage-backed securities was based more in the misrepresentation of the risk than in the risk itself.
How about banking system stability? Banks are indeed more stable. Only 17 banks failed in 2014 compared to 140 in 2009 — but on the flip side, few new banks have been approved. By definition, weaker, less-capitalized banks have been weeded out. Even with a threshold of $50 billion for increased scrutiny, smaller banks and credit unions have struggled to deal with the regulatory requirements.
Arguably, the "too big to fail" issue still exists, and may be even worse with higher concentration of US banking capital in the larger banks, but at least they are being forced to keep sufficient capital to provide an economic buffer in case of economic shock. They must also submit shutdown plans—so-called "living wills"— to ensure that an individual bank failure doesn't cascade through the system and require bailout. The exercise of writing these living wills is giving banks and regulators a greater in-depth understanding of the interconnected financial system, which can only be a good thing.
Of course, if banks are holding more capital, they cannot put that capital to use in the greater economy — it becomes a form of insurance. It is up to you whether you consider that a good or a bad thing.
To control riskier trading practices, Dodd-Frank created a regulated trading platform for swaps that took effect in 2013. Meanwhile, the Volcker Rule that recently went into effect keeps larger investment banks from engaging in speculative investment and proprietary trading. As expected, these measures have throttled back the risk levels of investments, thus making it more difficult to create larger returns. It's virtually impossible to measure the bill's effect truly, since so many other factors affect investment returns, but in both cases, the law seems to have been effective in carrying out its intent.
The Consumer Financial Protection Bureau (CFPB), the financial watchdog agency created by Dodd-Frank, has certainly been active since its inception in 2011. CFPB has secured over $10 billion in compensation for consumers that have been affected by financial impropriety, from fraudulent mortgage practices to illegal debt-collection methods to predatory lending.
The CFPB is generally considered as a positive outcome of Dodd-Frank at the moment, but critics rightly point out that oversight of the CFPB is lacking. According to the Wall Street Journal, "CFPB funding is not subject to congressional appropriations, and Dodd-Frank requires courts to grant the bureau deference regarding its interpretation of federal consumer-financial law."
Your beliefs about the overall effectiveness of Dodd-Frank depend on your perspective on the US financial system, and most likely your political views. However, by one classic measure of effectiveness, it is successful — most people have both something to cheer about and to complain about. Usually that is a sign of legislation that is getting to the root of underlying problems and at least partially accomplishing its goals.
We will really find out how effective Dodd-Frank is when the next major shock to the financial system occurs. It's a huge leap of faith to assume Dodd-Frank will prevent one.
Photo ©iStock.com/ Christine Glade