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Dodd-Frank's future, and impact remains cloudy

Preservation efforts to prevent financial turmoil collide with efforts to kickstart the US economy

In an effort to drive economic growth, President Donald Trump signed an executive order in early February 2017 to restructure the Dodd–Frank Wall Street Reform and Consumer Protection Act. "We expect to be cutting a lot out of Dodd-Frank," Trump said, stating that businesses "can't get any money because the banks just won't let them borrow it because of the rules and regulations in Dodd-Frank."1

This significant collection of financial services laws and regulations was a product of the 2008 financial crisis. Commentators say a complete repeal is unlikely because Congress remains deeply divided over Dodd-Frank, but significant changes are possible.

"We expect to be cutting a lot out of Dodd-Frank"

On May 4, 2017, the House Financial Services Committee voted to pass the Financial Choice Act, a Republican-sponsored bill that intends to repeal significant portions of the Dodd-Frank framework. The bill now goes to the House of Representatives for further consideration.

A Challenge to Regulations

Advocates for repeal of Dodd-Frank assume that increased regulation reduces options and raises costs particularly for the small businesses that are important to US job creation and economic growth. Concurrent with the law's introduction, loans to small businesses dropped approximately five percent by the end of 2012, and the initial impact was alarming to lenders.2

Even though lending to small businesses increased by 14 percent by the end of 2015, companies received significantly less in loans than requested. The smaller the company, the larger the shortfall. For example, 73 percent of companies with annual revenues greater than USD 10 million were fully funded. However, this fell to 45 percent for businesses with annual revenues between USD 100,000 and USD 1 million, as reported by the Federal Reserve.3

Dodd-Frank is a likely cause, say market observers. Small banks, they argue, are the most important source of financing for small businesses. Since they cannot spread compliance costs over a large asset base unlike large banks, they are at a competitive disadvantage as lenders. It is claimed that adjusting specific areas of Dodd-Frank related to compliance that have proven to be the most difficult for smaller financial institutions may help relieve financial pressure and allow them to direct more capital to lending.4

Another potential candidate for modification is the restriction on the authority of the Federal Reserve and Federal Deposit Insurance Corporation (FDIC) to intervene during a crisis. The Fed is no longer permitted to make emergency loans to non-bank financial service firms, and the FDIC cannot provide debt guarantees unless supported by Congress. These important tools that helped restore the economy after 2008 would not be readily available in the event of a similar emergency, according to the Brookings Institution and Bipartisan Policy Center (BPC).5

The more complex the structure, the more difficult and costly compliance becomes for financial institutions

In addition, the overall structure and overlap of financial regulatory bodies could be simplified. The more complex the structure, the more difficult and costly compliance becomes for financial institutions. Although Dodd-Frank closed the Office of Thrift Supervision, it replaced it with the Consumer Finance Protection Bureau (CFPB), Office of Financial Research, and the Financial Stability Oversight Council but did not establish a clear path to governance.6

Reform Lite

Advocates for Dodd-Frank say the legislation strengthened the financial system in meaningful ways and that some aspects should remain. As the Brookings Institution and Bipartisan Policy Center noted, banks held too little capital for sound risk management before the financial crisis. Supporters of Dodd-Frank argue that retention of higher capitalization would be prudent for the industry, economy, and investors. They point out that after Dodd-Frank, the largest banks sharply increased their capital levels from eight to approximately 14 percent, helping ward off liquidity challenges.

Technological advancements, anti-money-laundering and know-your-customer requirements stimulated by Dodd-Frank legislation also created unexpected benefits for many banks. Data that compliance systems gathered across multiple lines of business for financial institutions to prevent criminal activity provided holistic views of their customers and stimulated business growth.7

Supporters of Dodd-Frank argue that retention of higher capitalization would be prudent for the industry, economy, and investors

The Volcker Rule provides an important mechanism for stability of the financial system. The regulation acts as a bailout backstop in an attempt to reduce moral hazard by requiring banks that receive FDIC insurance to establish separate legal entities for proprietary trading. Treasury Secretary Steven Mnuchin indicated his support for the rule during his confirmation hearing, although he has called for more clarity of wording so banks "can [better] understand what they can do and what they can't do."8

The FDIC single-point-of-entry strategy improves financial stability with standard procedures to safely address a failed financial institution. By making use of the holding company structure of most banks, the FDIC can isolate the problematic entity and avoid a chain reaction through other affiliates and subsidiaries.9

Any regulatory reform undertaken by the Trump administration will be judged against the background of the economic circumstances that led to the creation of Dodd-Frank. Improvement of regulatory structures is always valuable, but deregulation risks the loss of mechanisms that strengthen the economy and protect systemically critical markets and industries.


Sources

  1. The Hill (February 3, 2017), Trump says 'business friends can't get loans' because of Dodd-Frank
  2. American Bankers Association (August 2016), State of Bank Lending
  3. Federal Reserve (March 2016), 2015 Small Business Credit Survey
  4. Mercatus Center, George Mason University (February 2014), How Are Small Banks Faring Under Dodd-Frank?
  5. Brookings Institution and Bipartisan Policy Center (October 24, 2014), The Impact of the Dodd-Frank Act on Financial Stability and Economic Growth
  6. Brookings Institution (February 6, 2017), What will happen to Dodd-Frank under Trump's executive order?
  7. CFO (March 7, 2017), Dodd-Frank: Benefits Among the Burdens
  8. United States Senate Committee on Finance (January 19, 2017), Hearing to Consider the Anticipated Nomination of Steven Terner Mnuchin to be Secretary of the Treasury
  9. Weil (March 24, 2014), FDIC Issues 'Single Point of Entry' Resolution Strategy