Hubert Shingleton
Associate Editor
Loyola University Chicago School of Law J.D. 2019
New discussions in the U.S. Senate indicate a likely repeal of 2010’s controversial Dodd-Frank Act. Designed in response to the 2008 economic crisis, the Dodd-Frank Act implemented regulations on banks and lending agencies to provide greater financial stability and consumer protection. The fundamental purpose of Dodd-Frank was to increase oversight and transparency among financial institutions. However, the Dodd-Frank Act has been the target of much criticism, most notably that its imposed regulations stifle the growth of smaller institutions. As of March 2018, Senate discussions indicate an intent to lay the foundations to remove this regulation.
Explaining the Dodd-Frank Act
Leading up to the 2008 financial crisis, large banks and financial firms invested heavily in bad derivatives. Once these derivatives failed to realize their expected values, many banks found themselves with inadequate financing or collateral to cover their losses. These financial institutions turned to the federal government for support, and in an effort to prevent full-scale financial instability, the government bailed out the investment firms in order to protect taxpayer-insured banks.
In response, the federal government passed the Dodd-Frank Act, which established new regulations to regulate market risks in lending agencies. Aside from governing minimum collateral values necessary for trading derivatives, the Dodd-Frank Act also regulates bank guidelines concerning liquidity values, capital management, and a number of managerial rules concerning use of bank assets.
Beyond these regulations, the Dodd-Frank Act created a range of stress tests for all major banks, where the assets of a bank determine which stress test to apply. Under the original Dodd-Frank regulation, the Federal Deposit Insurance Corporation (“FDIC”) requires all banks with assets greater than $10 billion dollars to submit an annual report of their company-run stress test. To perform a stress test, the FDIC has developed a series of templates detailing various market scenarios and testing methods. It is then the duty of banks and savings associations to analyze the scenarios in light of their own assets and capital.
Ultimately, the stress tests assess a financial institution’s capital adequacy and develop a risk profile to determine the exposure that the bank creates for the FDIC. Running annual stress tests ensures that institutions have adequate capital necessary to operate during times of economic or financial stress. An additional, substantive portion of the stress test requires an examination of a bank’s ability to internally identify and measure risk during the capital planning process.
Unrest Under Dodd-Frank
Since its inception, the Dodd-Frank Act received a lot of criticism. A frequent bipartisan critique is that the Dodd-Frank Act creates artificial barriers between large and small banks, and along this dividing line, disparate treatment of the banks unfairly punishes medium-sized Institutions.
While all institutions over $10 billion must file a response to the FDIC’s annual stress test, the FDIC creates two additional tiers of separation. The FDIC differentiates between banks with assets along the $50 billion line. Along the three tiers of bank assets, the FDIC stress test requirement is not equal. The greater the asset value, the stricter the rules are controlling capital, mergers, dividends, and stress tests.
As a bank’s assets appreciate, the Dodd-Frank Act requires greater oversight and accountability from a bank’s internal compliance team. Critics of the Act feel that $50 billion is an artificial constraint created by the FDIC, and regulations imposed past this asset value have a disparate impact on medium banks when compared titans of industry like J.P. Morgan Chase.
In response to this criticism, the Federal Reserve granted reprieve to twenty U.S. banks with less than $250 billion in assets during the 2017 stress test. Rather than needing to comply with the full stress test, banks below this asset range were given the opportunity to abstain from complying with the second-half of the stress tests, which require a subjective investigation of their respective risk-management systems.
Moving Forward
2017 saw the Federal Reserve excepting part of the stress test, and it seems likely that amendments to the Dodd-Frank Act will soon codify the Federal Reserve’s exception in 2018. On March 1st, Mitch McConnell procedurally laid the foundation for a new bill. Following the long debate concerning the artificial limitations of Dodd-Frank’s tiering system, bipartisan legislation looks to raise the upper threshold of the Dodd-Frank tiering system to $250 billion instead of the previous $50 billion maximum on regulation.
Proponents of this bill believe that this alteration to the Dodd-Frank Act will encourage small banks, who have been forced to consciously avoid growth, to engage in greater practice of mergers and acquisitions. Because of the previous $50 billion upper boundary on remaining a small bank, many banks have been forced to avoid moderate growth out of fear of receiving harsher restrictions from the Dodd-Frank Act.
Critics of this legislative movement point to deregulation as an injection of greater risk into the financial system while the markets are volatile. Advocates against this change point to the consistent, deregulatory aim of the current presidential administration as a grounds for caution in the face of removing further financial regulations.
Ultimately, it seems highly likely that some legislative change will occur. Critics of the Dodd-Frank Act have been vocal since its inception. McConnell’s bill has widespread, bipartisan support, and in light of the historical criticisms of the Dodd-Frank Act, these changes will be welcomed by many.