The Effects of Dodd-Frank

Introduction

In 2010, Dodd-Frank Act was enacted as a response to the problems of financial facilities exposed during the financial crisis. It has been regarded as the most comprehensive and strictest financial reform act since the Great Depression. This act pays attention to the protection of investors and the supervision of financial facilities. Related financial institutions like Federal Reserve are endowed with more supervision rights. Financial facilities, like investment banks, have to increase the transparency of its dealings and accounts, as well as reduce the risk of its derivative financial products. With the change of the government’s attitude, financial facilities can no longer rely on the previous practice of “too big to fail” as many large financial facilities, like Merrill Lynch and Lehman Brothers, went bankrupt successively. This paper aims at analyzing the effects of Dodd-Frank Act by its three main purposes: promoting the financial stability of the United States, protecting the American taxpayer and customers, and increasing the supervision of financial facilities.

Promoting the financial stability

The Dodd-Frank Act establishes a new regulatory coordination system to end “too big to fail” phenomenon in the financial industry. This new system clarifies the responsibility of each party in the financial activities and related supervising responsibilities. This management of the financial system improves the efficiency of regulations and avoids regulatory overlaps. Also, a new Financial Stability Oversight Board is set specifically for ensuring the effective supervision of financial facilities in order to avoid any systemic risk. Before the financial crisis in 2008, the “too big to fail” phenomenon was very common in the financial industry. Due to this phenomenon, financial facilities took many irresponsible investments and transactions that caused the high leverage effect and subprime crisis. Also, the indifferent attitude of the government institutions enabled these financial facilities to manipulate the market and transfer the risk to their investors and customers. The financial crisis in 2008 exposed the monopoly and polarization phenomena in the financial industry. The consequence of these financial facilities’ shorting of the market directly caused the eruption of this financial crisis (Kider 2011). Thus, this Act creates a new regulatory coordination system for this “too big to fail” phenomenon and reduces the possibility of financial facilities shorting the market and manipulating the price. Cases like Lehman Brother and AIG prove the previous irrational attitude towards financial facilities which make their bankruptcies a great influence on the market. This new system creates a new regulatory framework of systemic risk to ensure their financial institutions take responsibilities of the related costs of their bankruptcies, not customers or taxpayers. In this way, financial institutions take full responsibilities for their investments and managements. Any risk of irresponsible investments and speculative investments will transfer to financial facilities so that financial facilities have to take their transactions and managements carefully in order to survive without the support of the government.

Meanwhile, the Dodd-Frank Act improves accountability and transparency, which enables customers and government institutions to have a clear understanding of the financial situation of financial facilities. According to this act, large-scale institutions are asked to register in Security and Exchange Commission (SEC) to disclose trading information for inspections. With the increasing transparency, financial facilities have few chance to manipulate the price and cheat customers. The SEC will play an important role to avoid irresponsible high-risk investments and speculative activities. Also, customers get more information about financial facilities and their financial situations, which enable them to avoid irrational investments. Before this act was enacted, financial facilities took the dominant position in pricing their derivative products and evaluate the risk of investments. Investors, on the other hand, had no bargaining chip due to their limited information on the market development and the financial power of those facilities. Due to this act, investors can invest based on the financial situation of those financial facilities to avoid losses. Moreover, this act reduces the over-the-counter (OTC) trading through the introduction of exchange trading and central clearing. The remaining OTC trading will be conducted in more extensive standards. 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). Proprietary trading is an important transaction for financial facilities. Derivative products and high-risk financial products are main products in this category. Financial facilities use these transactions to earn great profits by attracting investors with high profits promised. However, these products are usually accompanied by high risks and uncertainties. The control of these transactions could limit financial facilities’ high-risk transactions. Moreover, high-risk derivatives are highly regulated to ensure investors’ interests. In this way, investment companies got few opportunity to earn great profits by speculations.

The financial protection of taxpayers and customers

The Dodd-Frank Act focuses on protecting taxpayers by ending bailouts so that they will not bear the risk if financial facilities go bankrupt. Financial facilities must prepare a certain amount of money as bailouts to prepare for the possible bankruptcy. The new way of clearing of bankruptcies of large companies spare taxpayers from paying for debts of those financial facilities. With the end of “too big to fail” phenomenon, financial facilities are forbidden to use taxpayers’ money as their bailout capitals. This measure puts greater financial burdens on financial facilities and forces them to think carefully because making high-risk investments. And with the increasing transparency and standardization of financial derivatives, taxpayers bear fewer risks in these transactions (Adler 2015). Without the backup bailout from taxpayers, financial facilities bear all the risk of their ineffective managements and irresponsible investments. If a financial facility goes bankrupt, it should clear its bankruptcy with its own bailout. This measure puts more capital pressure on financial facilities and controls their current capital for more high-risk investments. Any high-risk investment must be considered carefully in case of huge debts and possible bankruptcies. Before this act was enacted, financial facilities had little control in their investments and transactions because the government would protect them for the “too big to fail” practice and even though their great losses in investments led them to bankruptcies, they bore no more debts as long as they declared bankruptcy. Taxpayers would pay their debts and clear the bankruptcy. But now, the government regulates them strictly, and all responsibilities related to the bankruptcy fall on those financial facilities. Any high-risk investment is supervised and limited. Financial facilities must put customers’ interests and profits before their own interests and profits.

The Dodd-Frank Act protects consumers from abusive financial services practices and avoids asymmetric information of financial products. This act creates Consumer Financial Protection Bureau to regulate the pricing of financial services and derivative products. Through a wide range of regulations, financial facilities have little opportunities to manipulate the price unilaterally and mislead customers of the value of their products. Examples during the financial crisis show that financial facilities, like Goldman Sachs and Morgan Stanley, created a huge bubble economy and let their customers pay their faults. Though many financial facilities went bankrupt and paid for their faults, customers suffered the greatest loss. Thus, to avoid these unnecessary losses, the pricing of financial services and derivate products will be paid extra attention by related supervision institutions, especially those services and products with high risks and high prices. Also, The Dodd-Frank Act protects customers and investors’ interests by ensuring transparency and reliability of investment advisers, financial brokers, and credit rating agencies. Customers and investors could not only acquire the financial situation of financial facilities, but also the reliable information and advice that they could take reference. The interest of investors is emphasized as the main duty of Wall Street brokers. Before this act was enacted, financial facilities acted as the main advisor to investors. They misled investors to purchase their derivative products with high risks. Investment advisers and financial brokers tended to share common interests with these financial facilities. These two parties worked together to manipulate investments in the market and left investors limited control of their investment choices due to the limited reliable information (Carney 2011). This act cuts the interests link between these two parties and monitors them separately with different institutions. Rating agencies are under stronger surveillance from independent authorizes to prevent conflicts of interest. In this way, investors are provided with reliable advice before they invest, and their reliable advice could control the risk to the minimum level.

The increasing supervision of financial facilities

The Dodd-Frank Act increases the supervision of financial facilities by adopting policies of executive compensation and corporate governance. This policy gives shareholders more rights to speak on executive compensation and golden parachutes. In other words, shareholders get more involved in the management of financial facilities and the asymmetric information between shareholders and managers could be avoided. Shareholders join in the supervision of financial facilities together with government institutions and put pressure on managers for a responsible management (Drawbaugh 2010). The interests of these managers are linked closely with financial facilities’ performances and shareholders’ satisfactions. Thus, managers have limited rights to take high-risk investments or irresponsible transactions. They need to be responsible not only to their customers but also to shareholders and themselves. Also, financial derivatives with high risks are specially supervised in case of irresponsible investments that short the market. The government sets up multiple institutions to supervise financial facilities in every aspect, like their transactions, derivative products, accountability and transparency, managers’ salaries, etc. This act establishes a new system that forces financial facilities to manage their transactions rationally and take responsibility for their customers’ interests.

However, the increasing supervision from the Dodd-Frank Act puts great pressure on small financial facilities and enlarges the polarization in the financial industry. Studies have shown that smaller banks suffer more from the restrictions of the Dodd-Frank Act. Small financial facilities, like community banks and street banks, even ended the practice of giving their customers free checking, as well as some businesses like mortgages and car loans (Alper 2011). These regulatory barriers aim at regulating large financial facilities and avoiding the shorting phenomenon in the financial industry. However, this act doesn’t distinguish the barrier set for big financial facilities or small financial facilities. Compared with large financial facilities, small financial facilities have weaker ability to deal with regulatory barriers, leaving them no choice but to be sold to those large financial facilities. By the acquisition of small financial facilities, the polarization in the financial industry becomes more and more serious. Without the support of the government and the bailout from taxpayers, small financial facilities bear a huge risk taking high-risk or big-scale investments (Rosenblatt 2013). They don’t have enough money to prepare for the possible bankruptcy, so their loaning abilities grow weaker. Without enough loaning transactions in the mortgage market, small financial facilities meet the capital shortage to maintain daily operations (Morgenson 2010). Instead of going bankruptcy, they have to be merged by large financial facilities. Meanwhile, too strict regulations leave financial facilities increasing risks and fewer supports. These measures play the positive effect of controlling high-risk and irresponsible transactions, but these measures also limit the development of the financial facilities in some degree. Bid financial facilities, like Goldman Sachs, should be targeted specifically by this act because these large financial facilities shorted the market and led to the financial crisis. The development of other small financial facilities is hampered, and employees in these small financial facilities meet the risk of long their jobs. The limited development in the financial industry means the unpromising employment rate.

Conclusion

To sum up, the enaction of Dodd-Frank Act plays an important role in regulating financial facilities and protecting interests of investors and taxpayers. This act improves the accountability and transparency of financial facilities and enables investors to understand financial situations of those financial facilities better. Also, information and advice from investment advisers, financial brokers, and credit rating agencies are required to be reliable so that investors could make smarter investments based on the information. This act ends the long-term “too big to fail” phenomenon in the financial industry and spare taxpayers from paying debts of financial facilities due to their bankruptcies. In order to survive in the competition, financial facilities must manage their investments carefully and choose their transactions wisely. They have been deprived of any possibility to short the market and create a bubble economy. The government sets up specific institutions to supervise every aspect of these financial facilities separately, but too strict limitations put great capital pressures on small financial facilities and force them to be merged by large financial facilities, which contributes to the polarization phenomenon in the financial industry.