The financial crisis may only have been ten years ago, but Congress is already dismantling regulations that prevented banks from pursuing risky lending practices that landed the economy on the verge of total ruin.
Specifically, the Senate voted to increase the size of banks that are considered “Too Big to Fail” to $250 billion, from $50 billion, relaxing regulations on dozens of banks. We’ll get into what “too big to fail” means later, and which banks are included.
Senators also voted to exempt more than two dozen banks from rules that previously required them to have contingency plans in place in case they run into financial trouble, CNN reports. And they also voted to free banks with $10 billion in assets or less from restrictions that prevent them from taking risky bets with their deposits, according to reports.
But let’s start at the beginning.
What was the Dodd-Frank Act?
Officially known as the Dodd–Frank Wall Street Reform and Consumer Protection Act, it was named after Chris Dodd and Barney Frank, the two senators who helped shepherd the bill through Congress in 2010.
The bill was a response to the subprime mortgage crisis in the financial services sector, where banks unwisely loosened credit standards for home loans to problematic borrowers, resulting in record defaults and the severe recession that began in 2008.
Dodd-Frank established new regulations to ensure that banks-which are responsible for lending and making sure money is available to consumers–wouldn’t seize up and threaten the foundation of the economy.
The biggest banks, whose potential failure could have an outsize impact on the economy, were subject to the strictest regulations. Banks such as JPMorgan and Citigroup and Bank of America, for example, have trillions of dollars of assets, and their businesses are sprawling, ranging from consumer lending to auto finance, insurance and mortgages.
Among the new rules, most big banks were required to keep more money on hand to make sure they had a cushion in the event of another financial crisis. They also were forced to undergo strict “stress tests” to ensure they could handle a sudden economic downturn.
Dodd-Frank also restricted the kinds of business activity banks could pursue. Remember the mortgage disaster? It was the result of years of selling subprime mortgages to consumers who couldn’t afford them, and who eventually stopped paying back their loans.
Banks began packaging those risky mortgages together into a trading tool called derivatives, which were then sold to investors. The derivatives grew so complex, that few people actually knew what was in them. When consumers stopped paying back their mortgages, these derivatives became worthless.
Dodd-Frank ended speculative activities like this for banks.
What are derivatives?: Derivatives are complex securities that rely on an underlying asset–in this case, mortgages–but take a bet either for or against the asset with something called an option or futures contract. These contracts wager on the value of the asset at some future point in time. For the average investors, derivatives are considered risky as they can encourage the irresponsible use of debt, known as leverage.
Among the new rules, most big banks were required to keep more money on hand to make sure they had a cushion in the event of another financial crisis.
What critics of Dodd-Frank say
Critics of the Dodd-Frank law have argued that the regulations have restricted growth in the banking industry. And numerous banking industry experts have said the capital requirements have especially hurt smaller banks, which have less money to begin with.
In particular, smaller banks have said they’ve had a hard time doing business, due to the increased regulatory costs, and requirements to have more cash on hand as a financial cushion.
What does “Too Big to Fail” Mean?
“Too Big to Fail” refers to financial institutions deemed to be “systemically important”. That essentially means any large financial institution whose failure could imperil not just the banking industry, but the entire economy. There are roughly 40 such companies, including U.S. Bank, Capital One, and the Bank of New York.
The phrase became popular in the aftermath of the financial crisis, which began in 2008. Some of the nation’s banks were on the verge of failing as a result of the subprime mortgage disaster, leading to a global cascade effect.
One of the most famous events leading to the crisis involved the failure of investment bank Lehman Brothers, formerly one of the most prominent banks on Wall Street. It closed its doors overnight, prompting a panic that the entire banking sector was running out of money and on the verge of collapse.
In the aftermath, more than 500 banks closed or had their assets seized by the Federal Deposit Insurance Corp. (FDIC), which insures customer deposits. To deal with the crisis, the federal government created something called the Troubled Assets Relief Program (TARP), which spent $700 billion bailing out the banks.
What’s happening now?
The Senate passed its measure on Wednesday with bipartisan support, 67-31: in other words both Democrats and Republicans voted for it.
But progressives, including Senator Elizabeth Warren (D-Mass.) have voiced objections.
“Washington is poised to make the same mistake it has made many times before, deregulating giant banks while the economy is cruising, only to set the stage for another financial crisis,” Warren told the Washington Post.
In addition to increasing the size of banks regulated by Dodd-Frank–now only about a dozen of the largest banks in the U.S. will be forced to comply, including JPMorgan, Citibank, Wells Fargo and Bank of America–the measure also frees the smallest community banks from requirements that they gather data on loans to consumers. That data is used by regulators to ensure banks make loans to minorities.
The bill heads next to the House of Representatives, which is expected to pass its own version.