The Dodd-Frank Act Explained

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After every major financial crisis over the past century, policymakers in the executive and legislative branches of the United States government have passed sweeping legislation to overhaul the way banks do business.

The Panic of 1907 prompted the Federal Reserve Act of 1913, which created our central bank. The Great Depression led to the Glass-Steagall Act of 1933, which established the Federal Deposit Insurance Corporation and prohibited the cohabitation of investment and commercial banks. And the litany of crises throughout the 1970s and 1980s convinced Congress to broadly deregulate the bank industry through a series of wide-ranging legislative acts.

It's only through this lens of historical context that one can truly appreciate the Dodd-Frank Act of 2010, which came on the heels of the financial crisis that erupted two years earlier.

Fighting the last war

Generals are often accused of "fighting the last war," in that they set their strategies going forward based on their most recent combat experience. This can be a mistake, of course, because times change. Strategies evolve. Adversaries adjust. Weapons systems advance.The same can be said of the intent behind the Dodd-Frank Act, which was conceived with the best of intentions.

Fissures in global financial markets were first exposed in August 2007 when a leading bank in Europe, France's BNP Paribas, stopped allowing investors to withdraw capital from two funds that held mortgage-backed securities.The situation escalated seven months later when Bear Stearns experienced a liquidity crisis. The investment bank's institutional clients stopped providing the funds the bank needed to stay afloat. Things got so dire that the federal government offered JPMorgan Chase(NYSE: JPM) a $30 billion loan to facilitate its acquisition and thus rescue.

But it wasn't until September 2008 that the crisis climaxed with the failure of Lehman Brothers, the nation's fourth biggest investment bank at the time. The stock market plummeted. Credit markets froze. And countless companies, both within the financial sector and outside of it, found themselves on the brink of failure. The fear pulsing through the credit markets was particularly alarming because it made it impossible for even the most creditworthy of companies such as General Electric to access the funds needed to cover its payroll and other ordinary operating costs.

The government's initial response was swift. It arranged Bank of America's (NYSE: BAC) purchase of Merrill Lynch. It nationalized all but a small sliver of American International Group, the massive insurance company that had insured vast swaths of investment securities backed by subprime mortgages. And it injected tens of billions of dollars' worth of capital into the nation's leading banks, including JPMorgan Chase, Bank of America, Citigroup(NYSE: C), and Wells Fargo (NYSE: WFC).

These were stopgap measures, however, more akin to CPR than to a long-term solution to cardiac problems. The latter came in the form of the Dodd-Frank Act, which was passed two years later in a heavily partisan vote spearheaded by Democrats and opposed by Republicans. "The White House will call this a victory," said then-Senate Minority Leader Mitch McConnell (R-KY). "But as credit tightens, regulations multiply, and job creation slows even further as a result of this bill, they'll have a hard time convincing the American people that this is a victory for them."

The too big to fail problem

The Dodd-Frank was designed to ensure that a financial crisis like that in 2008 won't happen again. As such, it sought to attack the principal problem that policymakers believed had caused the crisis in the first place -- the growth and proliferation of too-big-to-fail banks.

The notion of banks being too big to fail has a rich history. Almost all of the greatest financial crises in American history were aggravated by the failure of large financial institutions, which further sapped confidence in the financial sector and, prior to the Federal Deposit Insurance Corporation's founding, led to the destruction of countless peoples' liquid wealth. This is why the eponymous founder of JPMorgan Chase worked tirelessly during the Panic of 1907 to stop the bank runs occurring up and down Wall Street at the time. His actions were vindicated two and a half decades later when an otherwise ordinary recession transformed into the Great Depression due to a tsunami of bank failures.

But it wasn't until 1984 that the term "too big to fail" became part of our broader lexicon with the failure of Continental Illinois, one the country's largest banks at the time. In an almost identical series of events to the ones that brought down Bear Stearns more than 30 years later, Continental Illinois saw its funding sources evaporate after rumored problems at the bank led institutional investors to empty their accounts.

Explaining the Dodd-Frank Act

In an effort to prevent crises like these in the future, the policymakers behind the Dodd-Frank Act underwrote a series of critical reforms. The act increases the amount of capital banks must hold in reserve, giving the banks an added cushion to absorb loan losses in future downturns. It similarly requires banks to keep a larger portion of their assets invested in things that can be easily liquidated in the event of a bank run -- namely, cash and government securities as opposed to term loans.

The act also subjects the nation's biggest banks to a series of heightened regulatory requirements not faced by regional and community banks. Under Dodd-Frank, every bank with more than $50 billion worth of assets on its balance sheet must submit to annual stress tests administered by the Federal Reserve, which then determines if they would survive a hypothetically severe crisis akin to the one in 2008. As a part of the stress tests, these banks must also seek regulatory approval to increase their dividends or authorize new share repurchase programs.

Even among the biggest banks, moreover, the Dodd-Frank Act makes distinctions. The biggest among them are classified as global systemically important banks, or G-SIBs, which must hold an additional tranche of capital, known as the G-SIB surcharge. This is particularly burdensome for JPMorgan Chase, Bank of America, and Citigroup which have to keep as much as 3% their shareholders' equity laying fallow in cash or low-yielding but highly liquid securities. These banks must also submit resolution plans to regulators each year, detailing how they could be resolved without causing harm to the financial markets in the event they go bankrupt.

The Dodd-Frank Act has reintroduced central tenets of the Glass-Steagall Act as well, which had been gradually eroded over the years after originally forbidding commercial banks from running trading operations. The iteration of the rule in Dodd-Frank, known as the Volcker Rule, outlaws proprietary trading at universal banks and thereby limits their trading operations to serving as market makers for institutional clients. And last but certainly not least among the major changes introduced by the Dodd-Frank Act was the founding of the Consumer Financial Protection Bureau, which is vested with the authority to protect consumers from unfair, deceptive, or abusive financial products and services.

At the end of the day, in turn, while one can argue about the prescience and necessity of the Dodd-Frank Act, there's simply no doubt that it has fundamentally transformed the banking and financial services industry. The main question now is whether or not this transformation will be permanent, or, as has been promised by policymakers of late, just a temporary blip in the history of banking that could soon go away.

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John Maxfield owns shares of Bank of America and Wells Fargo. The Motley Fool owns shares of General Electric. The Motley Fool has a disclosure policy.