A Business Report of Dodd-Frank’s Impact on Investment Banks

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Summary

With lessons of the 2008 global financial crisis, the Dodd-Frank Act was enacted in 2010 to regulate the financial industry strictly. Proprietary trading and high-risk derivative business of investment banks were strictly limited and regulated. With the end of “too big to fail” attitude towards financial institutions and the increase of customers’ protection, investment banks got limited opportunities to manipulate the trading business with the increase of transparency. The Dodd-Frank Act strictly regulated investments and businesses of investment banks to avoid any speculative trading or unilateral pricing.

Problems of Investment Banks during the Crisis

Investment banks played an important role in the financial crisis. Their irresponsible investments and transactions caused the high leverage effect and subprime crisis. Due to the “too big to fail” policy before the crisis, regulatory institutions and the Federal government didn’t pay much attention to their high-risk trading. Also, in order to avoid regulations from related institutions and the government, investment banks launched many financial derivatives for their own profits. This market operation practice led to the polarization and monopoly, with big banks growing bigger while small banks being acquired. Large investment companies, like Goldman Sachs and Morgan Stanley, shorted the financial market and created a huge bubble economy. This bubble economy caused investors great losses and helped contribute to the financial crisis in 2008.

Legislative Solutions

With the enacting of the Dodd-Frank Act, investment banks were under a strict regulation of their transactions. According to this act, proprietary trading and high-risk derivative business were the focus of the supervision. The scale of hedge fund and private equity were limited no more than three percent of the bank’s tier one capital (Paletta 2010). Moreover, high-risk derivatives are highly regulated to ensure investors’ interests. Also, transactions of precious metals are prohibited in the over-the-counter market. In this way, investment companies got few opportunity to earn great profits by speculations. Statistics showed that proprietary trading occupied about ten present of the bank’s income (Chen 2012). This part of the income was controlled safely by the Comptroller, the FDIC, and the Federal government for the protections of customers.

In addition, investment banks were forbidden to use investors’ money as their bailout capitals. This measure put greater financial burdens on investment banks and forced them to think carefully because making high-risk investments. Meanwhile, the end of “too big to fail” attitude warned investment banks that their irresponsible investments were on longer neglected by related institutions. With lessons from bankruptcies of Merrill Lynch and Lehman Brothers, investment banks had to handle their transactions and managements carefully in order to survive. And with the increasing transparency and standardization of financial derivatives, investors bore fewer risks in these transactions.

Conclusions

The Dodd-Frank Act played a very positive role in regulating the financial market. Some regulations, like limitations of proprietary trading and high-risk derivative business, specifically aimed at problems of Investment banks before the crisis. With the increasing transparency and the protection of investors, investment banks had few chances to short the market and make speculative transactions. And the attitude change from the government forced them to regulate their transactions carefully because investors’ money was no longer their bailouts. In order to survive, investment banks had to concentrate on the effective management and responsible investments, not speculative transactions or shorting the market.