The House Financial Services Committee this week considers implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Congressional oversight of implementation is critical but there’s a risk that the hearings will degenerate into yet another salvo against much-needed financial reform. In fact, some in the financial sector and in Congress are now calling for repeal and are seeking to defund the agencies charged with implementing consumer financial protection, investor protection, and derivatives regulation.
Critics argue that reform will hurt jobs and stifle growth. But the opposite is true—the lack of strong financial regulation is what nearly sent our economy over a cliff during the Great Recession. It’s what cost our country so many jobs, homes, and businesses. So let’s take this opportunity instead to take a step back and remember why reform is necessary.
Before Dodd-Frank, major financial firms were essentially regulated by what they called themselves rather than what they did, with the legal name often determining regulation by the least stringent supervisory agency or no supervision at all. Huge amounts of risk moved outside the more regulated parts of the banking system into the so-called “shadow banking” world, leaving these firms subject to less oversight, lower capital requirements, and weaker consumer-protection rules.
Today, Dodd-Frank provides authority for clear, strong, and consolidated supervision and regulation by the Federal Reserve of any financial firm—regardless of legal form—whose failure could pose a threat to financial stability.
Before Dodd-Frank, the government did not have the authority to unwind large, highly leveraged, and substantially interconnected financial firms that failed. Think Bear Stearns, Lehman Brothers, and American International Group Inc.—all of which collapsed amid the 2008 financial crisis, threatening the very stability of the broader financial system. These and other "too-big-to-fail" financial institutions reduced market discipline, encouraged excessive risk-taking, provided an artificial incentive for financial institutions to grow, and created an uneven playing field.
Today, Dodd-Frank ends "too big to fail." Major financial firms will now be subject to heightened prudential standards, including higher capital requirements. By forcing firms to internalize the costs they impose on the broader financial system, they will have strong incentives to shrink and reduce their complexity, leverage, and interconnections. And should such a firm fail, there will be a bigger capital buffer to cushion losses.
Moreover, our nation no longer has to make the untenable choice between taxpayer bailouts and market chaos. Instead, Dodd-Frank provides the Federal Deposit Insurance Corporation with the authority to wind down any firm whose failure would pose substantial risks to our financial system—in a way that will protect the economy while ensuring that large financial firms, not taxpayers, bear any costs.
Before Dodd-Frank, no regulator had the responsibility to look across the full sweep of the financial system and take action when there was a threat. Today, the new Financial Stability Oversight Council boasts clear responsibility for examining emerging threats to our financial system regardless of whence they come.
Before Dodd-Frank, enormous risks grew up in the shadows of the over-the-counter derivatives market for financial products such as credit default swaps, which had a notional amount of $700 trillion prior to the financial crisis. Today, regulators are putting in place the tools to comprehensively regulate the derivatives market for the first time. The new financial reform law provides for transparency and price competition. It moves the market toward central clearing. It provides for strong prudential, capital, and business conduct rules for all dealers and other major participants in the derivatives markets. And it combats manipulation, fraud, and other abuses.
Before Dodd-Frank, consumer-protection regulation was fragmented over seven federal regulators, with no accountability. So-called nonbanks—among them mortgage brokerages and payday lenders—could avoid federal supervision altogether. Banks could choose the least restrictive consumer approach among competing banking agencies. Federal regulators preempted state consumer-protection laws without adequately replacing these safeguards. Fragmentation of rule writing, supervision, and enforcement led to finger-pointing in place of action and made actions taken less effective.
Today, Dodd-Frank ensures there is one agency accountable for one marketplace with one mission—protecting consumers. The Consumer Financial Protection Bureau will help consumers by giving them the tools to make their own choices and weed out bad practices.
Despite outcries to the contrary, these reforms are all about restoring the necessary balance between the incentives for innovation and competition, on the one hand, and adequate protections for consumers and investors, on the other.
So that is where we were before the Dodd-Frank Act, why reform was necessary, and how Dodd-Frank delivers the necessary reforms. Now is not the time to undercut Dodd-Frank and return to a financial system that caused widespread harm to our economy, our businesses, and our people. Now is the time to fully implement the reforms to safeguard our financial system, our economy, and American consumers.
Michael S. Barr is a Senior Fellow at the Center for American Progress and a professor of law at the University of Michigan Law School. He served as assistant secretary of the Treasury for Financial Institutions and was a key architect of the Dodd-Frank Act.