By Valentin A. Araneta
US President Donald Trump, in embracing and carrying out the Republican Party platform of deregulation as well as to fulfill his own campaign promises, has signed an executive order for the US Treasury Secretary to review existing financial regulations “expecting to cut out a lot from the Dodd-Frank Act. In order to better understand what this means and its implications, it is best to put the Dodd-Frank in the historical context of what brought it about.
The long title of the Act at issue is the Dodd-Frank Wall Street Reform and Consumer Protection Act. “An Act to promote the financial stability of the United States by improving accountability and transparency in the financial system, to end “too big to fail,” to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices…” It was introduced in the US House of Representatives by Barney Frank and in the Senate by Banking Committee Chairman Chris Dodd. The Act was a fundamental policy response to the financial crisis of 2008 that caused the great recession of 2008-2009. This crisis was triggered by the assets that financial institutions mainly of the US and Europe had put into their balance sheets or hedged against or sold to the public and other financial institutions which turned bad. The US government as well as other governments had to step in to bail out the financial institutions as well as the economy to prevent a meltdown of the financial system and thus causing the US and even the global economy from plunging into an economic depression. One of the measures that was signed into law by President Bush in 2008 was the Emergency Economic Stabilization Act which created the Troubled Asset Relief Program(TARP). The TARP program authorized expenditures of 700 billion dollars to support financial institutions and other systematically important institutions.
The Dodd-Frank Act is essentially a comprehensive financial reform policy framework to strengthen the system and to prevent similar crises from happening again. There can be a better appreciation of the purpose and rationale of the Dodd Frank Act by going back to the Glass-Steagall Act or the Banking Act of 1933. This Act was also a fundamental and comprehensive reform response to the meltdown of the US financial system that triggered the stock market crash of 1929 and the worldwide great depression from 1929 to 1939. One-third of the number of banks in the US had collapsed. One of the hallmark features of the Glass-Steagall Act was the separation between the commercial banking functions of deposit taking and lending and the investment banking functions of underwriting and trading in securities. Its purpose was to protect depositors’ money from being put at the risk of market movements by being used to finance positions in the stock and bond markets. The Federal Deposit Insurance Corporation was established under this Act to insure deposits in banks up to certain limits per account. Deposit insurance was recognized as a pillar for maintaining the stability of financial systems and today, most economies have deposit insurance or deposit guarantee schemes as part of their respective financial systems.
As the US economy and its financial system developed,the delineating lines between commercial banking and investment banking blurred. Commercial banks and Investment banks took on more of each others’ activities through loopholes and holding companies. Finally, the Gram-Leach-Biley Act of 1999 repealed the Glass-Steagall Act. Nine years later, the collapse of the investment bank Lehman Brothers triggered a crisis that necessitated the rescue of the biggest commercial and investment banks in the US through capital infusion by the government and the guarantee of assets. The irony is that if the Glass Steagall Act had been in place in its original form, it seems improbable that the crisis of the magnitude of 2008 would have happened.
Seeing the Dodd-Frank Act in a historical context, one can see its need as a financial reform framework to have a stable and robust financial system that protects the public from the vagaries and risks of economic and financial market movements as well as the mismanagement of financial institutions. Among the features of the Act are: the mandate to oversee financial stability through the Financial Stability Oversight Council and the ability of regulators to impose stricter regulations on large financial institutions that may be classified systematically important financial institutions or SIFIs; stricter governance requirements covering the accountabilities of the board and management and transparency: capital requirements calibrated to size, complexity and nature of risks with regular stress tests to monitor the adequacy of capital; bank holding companies with total assets of 50 billion dollars or more must submit annually resolution plans known as the “living will” to describe the company’s orderly resolution in the event of failure of the company; the Volcker Rule prevents US banks from using its deposits in making trades for the bank’s own accounts or proprietary trading which do not benefit the customers.
The Volcker Rule in particular is a déjà vu of the Glass Steagall Act because it controls once again the risk taking that banks can take with the depositors’ money. Since one of the principal mandates of the Dodd-Frank Act is to prevent the taxpayers’ money from being used to bail out mismanaged banks, this should be embraced by the Republican platform of “less government in business”. However, in the process of attaining this tight regulatory monitoring and enforcement actions have to be in place. The lessons of the Great Depression and the Great Recession strongly suggest that it is better to have strong regulatory processes in the financial system. In this light, what the US Treasury Secretary will come up with after carrying out Trump’s executive order bears close watching.
The opinions expressed here are the views of the writer and do not necessarily reflect the views and opinions of FINEX. You may email Mr. Araneta at firstname.lastname@example.org