U.S. President Donald Trump’s unsuccessful attempt to repeal Obamacare raises the question of how he will approach another of his targets: the Dodd-Frank Act that aims to protect consumers from self-serving financial services.
What is the purpose of these financial regulations and why are they important?
Does it make sense to jettison them to make the financial industry more efficient and ease constraints on corporate lending?
How does this fit in with Trump’s campaign rhetoric about the “self-serving Wall Street elite”?
By Lorenzo Raffaele
After failing last week to muster enough votes in Congress to repeal Obamacare — his predecessor’s health care law — U.S. President Donald Trump said he would turn his attention to other priorities such as trade and tax reform.
Among other pieces of legislation that Trump has in his sights is former president Barack Obama’s attempt to reform the U.S. banking system.
Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act in July 2010 in response to the financial crisis of 2007-8. Trump has called the law “a disaster”.
Last month, the new U.S. president signed an executive order to repeal the Act, but it’s not clear what he wants instead.
Proponents say Dodd-Frank has cut excessive risk-taking.
The Dodd-Frank Act reshaped the financial framework in America.
Previously, the American financial sector was characterized by the relatively free movement of capital and few laws regulating banking operations. There was relatively little supervision of investment advisers’ activities, hedge funds or private equity firms.
Since 2010, U.S. banks can no longer trade risky financial assets without increasing equity capital, which in practical terms means to have more cash reserves. This is meant to lower risk and the chance of failure.
What is more, proprietary trading has been banned under the “Volcker rule”: banks are not allowed to use customers’ deposits to trade for their own profit because this is seen as an inappropriate use of depositors’ money.
Lastly, important regulatory agencies such as the Financial Stability Oversight Council (FSOC) have been established. Their role is to eliminate excessive risk and the economic distress caused by the default of “too big to fail” financial giants – companies so large and so interconnected that their failure would be disastrous to the greater economic system.
Proponents say the Act made the U.S. financial system more solid and has helped the United States recover from recession by cutting excessive risk-taking.
Some think Dodd-Frank could make bank defaults more likely.
If the American economy is now stronger than its European counterpart, it is partly thanks to this “bitter pill”. In fact, the Federal Reserve — the U.S. central bank — recently raised interest rates to head off a potential overheating of the economy.
But opposition from Wall Street to Dodd-Frank has been strong from the beginning. The law substantially limits the degree of speculation available to banks, tightens supervision even for smaller advisers and promotes public accountability through newly established control agencies.
Several Dodd-Frank rules are still incomplete, and the Act as a whole has come under attack for its complexity. Some economists question its general effectiveness.
In a 2012 paper, economists Sohhyun Chung, Jussi Keppo and Xuchuan Yuan argued that the Act raised big banks’ default probability rather than minimizing it.
Gary Cohn, Trump’s chief economist adviser, told the Wall Street Journal that “more and more capital is getting held by the banks, never getting out to Main Street America”.
This echoes the main argument of advocates of a roll back of Dodd-Frank: That deregulation of the banking system would spur economic growth and create jobs.
The prospects of Dodd-Frank being modified or repealed depend on politics rather than business. Republicans have 52 seats in the Senate and would need eight Democrats to support legislation to ease strictures on banks.
Deregulation is best done carefully.
At this point, it seems unlikely that Dodd-Frank would be swept away entirely. But banking regulations have piled up in America and are now a source of disgruntlement for many small firms.
If the law were dismantled, risky speculation could accelerate. With the global economy picking up pace, many countries could follow in America’s footsteps. It is precisely this kind of overconfidence that contributed to the 2008 financial crisis.
Deregulation is a tricky business and is best done prudently, especially when it involves some of the world’s biggest banks.
The haste with which the Trump administration set out to repeal Obamacare probably led to the humiliation of being forced to withdraw the draft legislation when it became clear it would fail on a vote in the House of Representatives.
The U.S. administration would do well to avoid similar failure when tackling Dodd-Frank.
(Edited by Emma Bapt and Robert Holloway)
Lorenzo Raffaele is an Italian second-year undergraduate student at King’s College London, studying Business and Management. He is interested in banking and finance, enjoys sports and composes music on the guitar in his free time. He is hoping to work in finance in the future.