Introduction
For a long time, there has not been answerability for Wall Street and activities of gigantic financial institutions brought the USA the most horrible financial meltdown since the Great Depression, with a reported loss of eight million jobs, botched businesses, a slump in housing costs, and drained individual savings. The letdowns that led to this crisis demanded a bold action to restore conscientiousness and responsibility in financial structures (Robertson, 2009).
A financial crisis is a term usually applied to a wide variety of situations where assets and financial institutions lose their value abruptly. It is a situation that causes panic in the population as they are scared of losing the value of their assets and thus it is greeted with a lot of fear (Bill, 2010). An example was the late 2000’s financial crisis which was the worst recession in the United States since the 1930s when the world experienced the great depression which resulted in the collapse of many financial institutions because of the liquidity shortfall in the market. The government however reacted by bailing out most of the companies which had suffered a major setback to return the economy to its original situation (Robertson, 2009).
The Dodd-Frank Act puts into practice amendments that, influence the supervision of financial institutions, present new resolution systems for large fiscal companies, crafts a new outfit responsible for executing and implementing compliance with consumer financial acts, brings in more rigorous regulatory capital obligations; reorganization the regulation of credit rating bureaus, changes to business governance as well as managerial compensation practices (Bill, 2010). This paperwork will try to look into this law to establish the essentials of a legal reform law which need to be taken care of to avoid financial crisis.
Impact of Frank Dodd’s Act on financial institutions
The major depression in recent years in the United States peaked in 2006, injuring many financial institutions in the world. There was a significant decrease in the investor confidence in the financial institutions as most of the investors felt that there is a likelihood of these institutions collapsing. All the companies and organizations were striving to reduce expenditure for the fear of the crisis (Nissen, & Buckingham, 2011). Most organizations opted to cut their production as a result of the decrease in the demand for the goods and services which the organizations are producing. As a result, there was retrenchment of employees so that the organization would be able to cope up with the financial crisis. The cutting down of the employees reduced the income of the people in the United States thus resulting in the decreased demand for the goods the companies are producing since the people are jobless and they cannot spend what they do not have (Bill, 2010).
The government and the central banks responded very quickly to avert an economic meltdown. The responses included legislation in monetary policies, fiscal stimulus, and institutional bailouts (Bill, 2010). These were measures taken to avoid a situation where the whole economy of the country collapses and the people are left jobless. Without the fast response of the government, there was a possibility of the companies closing down and all the employees being dismissed (Skeel, 2011). This would lead to an increase in the lack of employment. In addition, it would lead to decreased production and thus decreased export. The domestic production would thus go down resulting in a collapse of the economy. Therefore, it was the obligation of the government to put up measures that would ensure that the financial institutions in the country do not collapse. This would result in the stabilization of the economy (Herr, 2010).
Dodd-Frank Wall Street reform and consumer protection Act was the main basis of prevention of financial crisis from happening again in the United States. It was signed into law by President Barrack Obama on 2010 July 21st and was the major agenda for the United States Congress which is democratically controlled (Skeel, 2011). This was part of the sweeping legal reform law that was passed after the financial crisis in late 2002. Therefore, it was a very important law. The main objective of the banks was to make more interest from the increased loans. The banks believed that the people who took loans would be able to pay back the loans soon with larger amounts of interest and thus make the banks earn more profit (Jay, 2009).
The law prohibits proprietary trading and limits funding or investing in private equity, and other different investment finances, subject to definite transition periods and exclusions (Jay, 2009). It also has provisions associated with derivatives payment and infrastructure. This sanction will affect banks with major investment banking actions, assuming a tapered description of proprietary trading in the appendage regulations. Risk withholding types, types, and sums for commercial mortgages will be resolved by regulators, including allowing an intermediary that procures the first-loss spot at issuance and holds ample financial resources to support losses thereby standing in for the risk retention prerequisite of the securitizer. Significant features were made between the activities that may be carried out by banking institutions and those that could be carried out by nonbank financial corporations with the oversight from the Federal Reserve. Except for certain authorized activities, banking entities cannot take on proprietary deals, or buy or retain any equity, joint ventures, or other rights in or pay for a hedge fund.
Non-Banking financial institutions that engage in proprietary businesses or fund activities will be required to have additional capital requirements in addition to quantitative perimeters, to be instituted by rule. Nonetheless, nonbank financial corporations which engage in permitted activities will have their capital requirements or quantitative boundaries applied; being equivalent to those of banking entities engaging in similar permitted activities (Davis, 2010). The act permits to purchase or retention of a possession interest or the backing of a fund by a banking entity exclusively outside of the U.S. whose interests in the fund are not tendered or sold to a U.S. inhabitant and the banking institution is not directly or indirectly managed by a bank categorized in the U.S. No action will be considered a permitted activity if it would lead to property conflict of interest for such banking entities, cause material exposure for the banking institution to high-risk assets or high threat business strategies or front a danger to the security and reliability of the banking institution.
The act permits hedging activities linked with underwriting or presenting the asset-supported security, on the condition that such activities are intended to trim down detailed risks to the financial liaison associated with places arising in connection with the asset-supported security offering. The restrain on funding private equity, and the other terms associated with derivatives would also have a sturdy effect on such banks’ proceeds if supplementing parameters are restrictive. Nevertheless, large financial institutions may restructure their business activities in a rejoinder (for instance by situating businesses in the companies which manage their assets). Consequently, it may be too soon to judge the general impact of the new set of laws (Davis, 2010).
Capital and liquidity
The Frank Act will influence U.S. banks as well as foreign banks’ partners in the United States that are structured as subsidiaries of overseas banks, particularly those with investment activities (Korten, 2009). The huge majority of international finance is intermediated by a small number of these institutions with rising interconnections in and across borders. Widespread developments that contributed to the global financial crisis involved considerable reliance on immediate wholesale funding, an increase in maturity mismatches, as well an augmented share of proceeds from multifaceted products and business activities (Davis, 2010). The main aim of Dodd’s Act is to encourage a less pulled, a lesser amount of risk and hence a more supple financial structure that supports muscular and protractible economic growth (Quick, 2010). The latest capital standards will include a considerable impact on savings and banking activities. Investment options will also be influenced by a swarm of other regulatory schemes, for instance, the new accounting policies and advanced standards for securitization, as well as procedures to contain certain activities. Nonetheless, financial institutions with an investment banking hub have elastic business sculpts and can amend their strategies without complexity to mitigate the results of the regulatory reforms, albeit a multitude of regulations shaping their activities (Davis, 2010). The eventual effect of the changes on business forms remains to be seen pending the regulation’s final shape (Grigore, 2009).
Systemic Changes
The crisis exposed the significant threats fronted by large, complex, and interrelated institutions and the loopholes in the regulatory and supervisory systems.
Over the earlier period preceding the crisis, banks in the USA significantly stretched in size and amplified their outreach internationally. In many instances, they shifted away from the habitual banking model on the road to regionally vigorous large and multifaceted financial institutions (Hillman, 2011). In the USA, regulatory ratios were not responsive to the upsurge of various threats and capital was not enough to offer a buffer (Jay, 2009).
The test for policymakers is to make sure that the adjustments in banks’ business approaches in reaction to tighter directives do not lead to a further loudening of systemic threats behind the scenes, either in unfettered sectors or in spots with less arduous regulatory standards (Grigore, 2009). Significant safeguards are thus required to mitigate these inadvertent consequences, at the same time also, minimizing adverse results on banks’ capacity to sustain the economic recovery (Hillman, 2011). To a great extent, the Dodd-Frank Act creates a Financial Stability Oversight Council given the responsibility of identifying and countering emerging threats in the fiscal system as a whole. Functioning through the Federal Reserve, which has the power to operate as the primary watchdog of all depository holding corporations and non-bank pecuniary companies categorized as systemically essential, the oversight committee can take steps to inflict additional capital, prerequisites on institutions thought to front risk to the financial system. Besides, a two-thirds vote can limit the escalation of a large organization if there is considered to be a danger to financial stability. This definition of the huge financial institutions has been left to regulators (Freedman, 2010).
Each of these procedures will eventually result in elevated capital rates of trade for the majority of financial institutions. Several financial institutions have by now started the course of reassessing business actions to baseline their feasibility and attractiveness in the framework of high capital and liquidity outlays. However, there are potential prospects, for multinational institutions that can contract their businesses to reap the available advantages (Freedman, 2010).
The act stops the option of taxpayers being asked to rescue banks that threaten the financial system by creating ways to liquidate unsuccessful financial institutions as well as imposing harsh fresh investment and control requirements that make it unattractive to get too huge (Reams, & Forrest, 2011). The act has established thorough standards and supervision to guard the financial system, consumers, and businesses. Banks are required to raise the level of security before lending to customers. One of the major reasons why the United States economy experienced a downfall was that there were so many people who had been loaned huge sums of money and were not able to pay back the loans. Thus, the regulations are to restrict the banks from lending money only to the people whose creditworthiness is not questionable. They should not lend money to everyone in the society without first establishing if that person can pay back the loan (Manz, 2010). It also sets the minimum amount of capital that the banks should have before they start financial services. This reduces the possibility of the banks collapsing with people’s money after they get some losses. One of the major problems which the financial institutions were facing at the time of the financial meltdown was that they were not able to compensate for the losses which their businesses have made. This was because of the less capital these financial institutions had and thus making them unable to operate (Morris, & Price, 2011).
The bank managers are supposed to be more careful in the lending of money. People who do not qualify for the loans should not get any loan since they risk the bank getting losses from the loans which will be unpaid. In addition, the bank should assess the ability of the individual to pay all the money which he or she has been loaned. This means that the bank should only give the amount which a debtor is able to pay without defaulting (Reams, & Forrest, 2011). As mentioned earlier, one of the problems which led to the financial crisis is that the banks were lending a lot of money to people which later became a problem. Ensuring that a person gets a loan which he or she is able to pay increases the chances of that person paying and reduces the chances of default (Freedman, 2010). Financial institutions that trade will witness momentous changes in the character and profile of the marketplace for goods and services.
The act outlines the agencies which are tasked with the responsibility of monitoring all the risks to which the bank is exposed. It also clarifies how the Federal Reserve will supervise the bank holding companies. There are two offices under this act and are attached to the department of treasury. The council has three main duties as per the act: First, it should identify the risks which pose a danger to the United States financial stability. These risks can either emanate from either financial organizations or non-financial organizations. Secondly, the council is tasked with the promotion of market discipline in financial institutions. The promotion of discipline among the financial institutions is by the elimination of the expectations in the financial institutions that the government will bail them when there is a problem. Thus, the council is very clear in its objective, that all the financial institutions are responsible for their running and if any of them is unable to operate because of financial difficulties, then it is the institution itself to come out of that problem but the government will not participate. Lastly, the council is tasked with responding to any threats which are emerging and may lead to instability of the United States economy. Thus, the council does a lot of research to ensure that it is up-to-date with all that is happening in the market and establish which of them is posing a threat to the economy of the United States. After the identification, it can take appropriate measures to ensure that the economy does not collapse (Freedman, 2010).
Conclusion
The economic crunch took scores of investors by surprise. It was apparent that investors in some financial products, for instance, auction-rate securities, never understood how the resultant market for those securities worked. Ponzi plots were exposed at a swift pace and consumers lost faith in the individuals in charge of their securities and/or finances. While various wholesale rations were watered down from the unique vociferous proposals covered at length in the media, noteworthy changes linger. Several of these, though, are issues for studies by controllers beforehand of comprehensive rulemaking, and for that reason, their ultimate shape may not be grasped for several years to come. The Act focuses on banking regulators including general threats as a supervisory concern, along with instruments to curtail the chances of the disintegration of a business that formerly would have been looked upon as too large to fail (Manz, 2010). It equips managers with information on how to manage the firm in case of failure by setting up a financial oversight council to coordinate the major financial to have a coordinated response to financial threats. A new autonomous watchdog, housed at the National Reserve, has the authority to guarantee American consumers unambiguous, correct information they need to buy mortgages, as well as other financial services, and cushion them from veiled fees, obnoxious terms, and misleading practices. This gives the oversight authority power to examine and carry out supervisory roles on businesses that are not operating well and may pose a financial threat to the entire system.
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