Dodd-Frank Wall Street Reform and Consumer Protection Act, better known as Dodd-Frank, is a multifaceted piece of financial regulation created in response to the 2008 financial crisis. It was signed into law in 2010 by the Obama administration in order to increase oversight of the financial regulatory system. It was the most sweeping rewrite of the country’s financial laws since the New Deal in order to limit widespread risk and prevent government bail outs of companies “too big to fail.”
Highlights of Dodd-Frank:
Financial Stability Oversight Council (FSOC)
A committee that was created to monitor large firms that could pose systemic risk, dismantle companies that grow too large, and mandate reserve requirements
Consumer Financial Protection Bureau (CFPB)
Prior to Dodd-Frank, the regulators for consumers were in existence but very fragmented. The CFPB is an independent agency that sets rules for the marketplace and supervises federal consumer financial laws.
- Federal oversight of banks and nonbanks in the mortgage market
- Account overdraft protection
- Greater credit card and student loan transparency
Prohibits banks from engaging in proprietary trading and limits the liabilities that the largest banks can hold.
The Concept of “Too Big to Fail”
The Volker Rule stemmed from the concept of Too Big to Fail. This is the idea that certain institutions are so large that their failure would be disastrous to the greater economic system; therefore, the government needs to step in if the institutions are facing instability. One view that arises with this concept is that these large institutions will take high-risk positions knowing that they have this safety net and that they should be made smaller.
The Future of Dodd-Frank
The Trump administration is leaning towards greater deregulation and has proposed the Financial Choice Act. This would dissemble and change parts of Dodd-Frank, but exactly how remains to be seen. Furthermore, the administration has a fair amount of power in the enforcement of Dodd-Frank. According to Harvard Professor Hal Scott, agencies like the Financial Stability Oversight Council can update their “guidance” instead of rules to make swift changes (such as when they deemed AIG and Prudential as significantly important financial institutions). If the Council were to deem institutions no longer significant, they would face much less regulatory pressure in terms of their leverage and risk ratios.
What does this mean for Commercial Lending?
As of now, the winding down of Dodd-Frank could be seen as a major boon to commercial lending. Small business loans have been in a downward spiral since 2008 due to the impact of high overhead costs that have inhibited banks from making loans less than $100K. If the government were to limit the agency’s powers as watchdog over the sector, commercial banks could more freely deliver loans to small business owners at competitive interest rates.
What does this mean for the Middle Market?
According to the Saratoga Investment Corp, banks act with the same hesitation towards the middle market that they do towards small businesses. Due to the risk weight ratios imposed under Dodd Frank, making a loan to a company with only $5MM in EBITDA could have a capital charge 10 or 20 times that of a loan to a much larger company with proportionally larger cash flows. These types of ratios have been the largest enabler of non-bank lenders who don’t have to operate under such strict ratios. A decrease in regulation could enable smaller banks to absorb some of the loans that they have lost recently to the online marketplace lenders; however, their products might not fit the changes in investor demands. Marketplace lenders have championed both accessibility and swiftness in their lending practices, and banks still won’t have the ability to process loans as quickly. Thus, the repeal of Dodd-Frank will primarily help marketplace lenders by increasing investment in the sector overall.