Dodd-Frank may be an American financial bill that’s being repealed but it can have dire consequences for the entire global economy, if replaced by something lax, as it was made to avoid another 2008 style financial crisis from happening.
The US House of Representatives on last week passed the CHOICE Act, a Republican reform bill aimed at repealing the Dodd-Frank Act, another one of Trump’s promises.
The Dodd-Frank Act was enacted in 2008 in the aftermath of the global financial crisis as a safeguard against the recurrence of such an event.
It may be an American financial bill that is being repealed but it could have consequences for the global economy, if replaced by something lax. One of the key objectives of the Dodd-Frank Act was to rein in banks from taking on too much risk.
Let us look at the chain of events that eventually culminated in the global financial crisis, beginning from the subprime mortgage crisis in the US.
IT’S THE YEAR 2008, THE SKY IS FALLING
The housing bubble in the US bursts, banks go bankrupt and the US government comes to the rescue by using millions of taxpayer money to bail them out.
Experts across the world term the crisis as a ‘black swan’ event, an unforeseeable recession but there were a few who had warned of such an outcome.
Former RBI Governor Raghuram Rajan was among the few who foresaw in 2005 the damage that subprime lending would eventually wreak on the financial system. Rajan had pointed that the incentives structure was horribly skewed in the financial sector, with top executives reaping rich rewards for making money but being only lightly penalized for losses.
With low risk exposure on failing, financial firms were encouraged to invest in complex products, with potentially big payoffs, which could on occasion fail spectacularly. Rajan was talking about “credit default swaps” which act as insurance against bond defaults.
Wall Street, which was enjoying massive deregulation at that time, began to create mortgage bonds from “subprime” mortgages. These loans earn higher returns for banks, but are also risky as the borrowers are people with low credit scores and often those who lack the means to make timely repayments.
Having made the loans, the banks then packaged them along with other fixed income assets into an instrument called collateralized debt obligations (CDOs). The underlying assumption was that CDOs were safe because all borrowers would not default at the same time.
When demand for CDOs rose, lenders began pushing loans to those with abysmal credit scores, and without the capacity to afford a mortgage.
These people were given home loans on variable rate, with extremely low (even zero) initial interest rates. But when the rates were reset higher after some time, there was a flood of defaults.
When customers defaulted, the CDOs held by financial institutions became worthless, causing massive losses.
After the collapse of Lehman Brothers, the Bush administration created USD 700 billion bailout plan for the banks as they were then termed ‘too big to fail’ and their collapse could drag the entire economy down.
This bailout was heavily criticized and to ensure that in a similar future situation taxpayers money was not exploited, the Obama regime came up with the Dodd-Frank Act to regulate Wall Street and make sure that if these ‘too big to fail’ institutions ever failed, then the collateral damage to the system was minimal.
Along with providing structured liquidation of financial institutions, Dodd-Frank listed various reforms to improve transparency and accountability on Wall Street.
Some of the most noticeable ones are Consumer Financial Protection Bureau, aimed to protect the common man from fraudulent banking practices and the Volcker Rule which stops banks from gambling with depositors’ money and bans them from using or owning hedge funds for their own profit.
Experts say that it is not a perfect act and requires several amendments but repealing it with the CHOICE Act, which will again heavily deregulate Wall Street will be a recipe for a huge disaster.
Must read: What is the Dodd-Frank Act, its drawback and Trump’s alternative – the CHOICE Act
CONSEQUENCES OF REPEALING DODD-FRANK
Like any financial reform, Dodd-Frank is not perfect and has a few flaws, which even its co-creator, Barney Frank admits. Frank believes that the financial reform law has been too restrictive on smaller banks the threshold used to identify other banks “as too big to fail” should be higher.
But experts believe that again deregulating Wall Street is not the solution.
Maybe, Raghuram Rajan explains it best: “In the past, financial regulation has always been pro-cyclical: we have a crisis, we regulate, we go too far. Then we deregulate, we go too far and have another crisis,” he had said in an interview.
If the CFPB is done away, there wouldn’t be a clear procedure in the US for how to deal with the recent Wells Fargo like fraudulent sales practices.
“[Dodd-Frank] put in place real guardrails against re-creating the kind of financial crisis we saw in 2008. It is inexcusable that the administration has targeted the most vulnerable people in our society to be the ones that bear the brunt of their ideological push,” says Michael Barr, University of Michigan Law School professor and a key architect of the Dodd-Frank Act.
[Copyright By IST]