On July 21, 2010, President Barack Obama signed into federal law the Dodd-Frank Wall Street Reform and Consumer Protection Act. Better known as the Dodd Frank Act, the law was enacted in response to the financial meltdown that occurred in 2007-2008.
The financial crisis of 2007–2008, also known as the Global Financial Crisis and 2008 financial Crisis, is considered by many economists to be the worst financial crisis since the Great Depression which began with the stock market crash in 1929. This was a worldwide crisis that continued until the late 1930’s for most countries and as late as the mid 1940’s for others.
October 29, 1929, which later became known as Black Tuesday, began a period when personal income, tax revenue, profits and prices dropped precipitously. International trade dropped by more than 50% and the unemployment rate in the United States rose to 25%.
Historians point to structural factors such as major bank failures and the stock market crash, while monetarist economists tend to assign the blame to monetary factors such as the actions taken by the Federal Reserve to contract the money supply and Britain’s decision to return to the gold standard at pre-World War I parities (approximately $4).
Credible arguments have also been made that loose credit caused over-indebtedness and and deflation. The over-indebtedness also fueled market speculation and asset bubbles. During the Great Depression, margin requirements were only ten percent (10%). As the stock market crash caused brokerage firms to make margin calls on investors who bought securities on margin, the banks were overwhelmed as these investors all sought to withdraw their funds at once. Banks began to fail as debtors defaulted on their debts and depositor withdrawals resulted in a run on the bank. By April of 1933, approximately $7 billion in deposits had been frozen in failed banks.
While the underlying causes for the 1929 crash were different than those which caused the Financial Crisis of 2008, there are some striking parallels in the actions that were taken by the Federal Government. In 1933, President Franklin D. Roosevelt signed the Banking Act of 1933.
Perhaps the most important provisions of this new legislation are known as the Glass-Steagall Act (actually passed in 1932) which limited commercial bank securities activities and affiliations between commercial banks and securities firms.
The Glass Steagall Act of 1932 authorized Federal Reserve Banks to (1) lend money to five or more Federal Reserve System member banks on either a group basis or to any individual member bank with capital stock of $5 million or less against any satisfactory collateral, rather than just “eligible paper” ; and (2) issue Federal Reserve Bank Notes (i.e. paper currency) backed by U.S. government securities when a shortage of “eligible paper” held by Federal Reserve Banks would have required such currency to be backed by gold.
The final cornerstone of the sweeping legislation enacted to address the Great Depression was the Securities Exchange Act of 1934. Signed into law on June 6, 1934, the “Exchange Act” established the Securities & Exchange Commission and established laws governing the secondary trading of securities (i.e. stocks, bonds and debentures) in the United States.
Essentially, the combined legislation was enacted to prevent large banks in engaging in risky and speculative investment and trading activity that could put both the general public and the U.S. financial system at undue risk. For many years, there was a clear separation between commercial and investment banking activity in the United States.
As the good times rolled on and U.S. banks fell from the top list of worldwide banks (as defined by assets), critics of the legislation began to argue for reform. Arguments were made that U.S. banks could no longer compete globally with European and Japanese banks that were not subject to such restrictions.
In 1999, after nearly seven decades, the Glass Steagall Act was repealed and the walls between commercial and investment banking came tumbling down. The $64,000 question is how much of an impact (if any) did the repeal of the Glass Steagall Act have on causing the Financial Crisis of 2008?
In 1999, Democrats led by President Bill Clinton and Republicans led by Sen. Phil Gramm joined forces to repeal Glass-Steagall at the behest of the big banks. What happened over the next eight years was a scary replication of the the activity of the banks during the Roaring Twenties. Once again, banks originated fraudulent loans sold them to their customers in the form of securities. The bubble peaked in 2007 and collapsed in 2008.
Big Bank supporters argue that the banks can not be blamed for fraudulent loan origination because the real culprits were unscrupulous mortgage brokers who were fueled by greed. Some like to argue that because there were not any major big bank failures during the latest financial crisis that these banks were not in fact the cause of the problem. I guess that we will never know the real truth because the government stepped in and bailed out (either directly or indirectly) some of the largest players in the industry.
The following timeline provided by ProPUBLICA illustrates the extent to which the federal government put the American taxpayer at risk: After stabilizing the financial markets in 2009, attention was turned towards enacting legislation to prevent the collapse of another major financial institution like Lehman Brothers and to insure that the federal government would not have to risk taxpayer funds to prevent a global financial melt down.
In 2010, the Dodd Frank Act became law and was named after Senator Christopher J. Dodd (D-CT) and U.S. Representative Barney Frank (D-MA), who were the sponsors of the legislation.
One of the main goals of the Dodd-Frank act is to have banks subjected to a number of regulations along with the possibility of being broken up if any of them are determined to be “too big to fail.” To do that, the act created the Financial Stability Oversight Committee (FSOC). It looks out for risks that affect the entire financial industry.
The Council is chaired by the Treasury Secretary, and has nine members including the Federal Reserve, the Securities and Exchange Commission and the new Consumer Financial Protection Bureau or CFPA. It also oversees non-bank financial firms like hedge funds .
One of the key provisions of the Dodd-Frank Act is called the “Volcker Rule”. The Volcker Rule prohibits banks from owning, investing, or sponsoring hedge funds, private equity funds, or any proprietary trading operations for their own profit. To help banks figure out which funds are for their profits and which funds are for customers, the Fed has given banks two years to divest their own funds in get in line with the rule before it’s enforced. Banks are however; permitted to keep any funds that are less than three percent of revenue. The Volcker Rule does allow some trading when it’s necessary for the bank to run its business. For example, banks can engage in currency trading to offset their own holdings in a foreign currency.
How Are We Doing Today?
The United States’ biggest banks (i.e. the ones that were “too big to fail” during the financial meltdown they helped to cause) have grown even larger since the crisis which has caused the Wall Street reforms of the Dodd-Frank Act, critics argue, clearly aren’t working. Assets at the seven biggest banks like Bank of America, Citibank, and JP Morgan Chase (which all have assets over $500 billion), have grown about 3% from the second quarter of 2010 when Dodd-Frank passed to the end of 2012, according to data from strategy firm Hamilton Place Strategies (HPS).
Although the big banks have gotten bigger since the enactment of the Dodd-Frank Act, the financial services community has become significantly more diversified as a result of the new legislation. The medium-large banks with $100-$500 billion under management (i.e. companies like Ally Financial, TD Bank, and PNC Financial Services Group) have grown by 70%. They’ve also increased their market share from 13% to 19% at the expense of their bigger competitors. Banks with $1 to $100 billion in assets also saw significant gains.
While no one can be sure what the future holds, it certainly appears that the Dodd-Frank Act has had some diversification impact on the banking sector.