Dodd-Frank Act: CNBC Explains

The term Dodd-Frank refers to a comprehensive and complicated piece of financial regulation born out of the Great Recession of 2008.

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CNBC.com

But what does it do and how does it really work? CNBC explains.

What is the Dodd-Frank Act?

The full name of the bill is the Dodd-Frank Wall Street Reform and Consumer Protection Act, but it is better known and most often referred to as Dodd-Frank.

In simple terms, Dodd-Frank is a law that places major regulations on the financial industry. It grew out of the Great Recession with the intention of preventing another collapse of a major financial institution like Lehman Brothers.

Dodd-Frank is also geared toward protecting consumers with rules like keeping borrowers from abusive lending and mortgage practices by banks.

It became the law of the land in 2010 and was named after Senator Christopher J. Dodd (D-CT) and U.S. Representative Barney Frank (D-MA), who were the sponsors of the legislation.

But not all of the provisions are in place and some rules are subject to change, as we'll see.

The bill contains some 16 major areas of reform and contains hundreds of pages, but we will focus here on what are considered the major rules of regulation.

What does Dodd-Frank do to regulate banks?

One of the main goals of the Dodd-Frank act is to have banks subjected to a number of regulations along with the possibility of being broken up if any of them are determined to be “too big to fail.”

To do that, the act created the Financial Stability Oversight Council (FSOC). It looks out for risks that affect the entire financial industry.

The Council is chaired by the Treasury Secretary, and has nine members including the Federal Reserve, the Securities and Exchange Commission and the new Consumer Financial Protection Bureau or CFPA. It also oversees non-bank financial firms like hedge funds .

If any of the banks gets too big in the council's determination, they could be be regulated by the Federal Reserve, which can ask a bank to increase its reserve requirement—the money it has 'saved up' and is not using for lending or business costs.

Under Dodd-Frank, banks are also required to have plans for a quick and orderly shutdown in the event that the bank becomes insolvent—or runs out of money.

What is the Volcker Rule?

The Volcker Rule is part of Dodd-Frank and prohibits banks from owning, investing, or sponsoring hedge funds, private equity funds, or any proprietary trading operations for their own profit.

To help banks figure out which funds are for their profits and which funds are for customers, the Fed has given banks two years to divest their own funds in get in line with the rule before it's enforced.

However banks can keep any funds that are less than three percent of revenue.

The Volcker Rule does allow some trading when it's necessary for the bank to run its business. For example, banks can engage in currency trading to offset their own holdings in a foreign currency.

But the Volcker rule is not in place yet, and some of its rules are still being decided. It is scheduled to go into effect in July 2012. However, regulators say they might not have all the rules in place by then.

How does Dodd-Frank affect derivatives?

Dodd-Frank requires that the riskiest derivatives—like credit default swaps—be regulated by the SEC or the Commodity Futures Trading Commission(CFTC).

To help make them more transparent, a clearinghouse of sorts— similar to the stock exchange—must be set up so these derivative trades can be transacted in public.

But Dodd-Frank left it up to the regulators to determine exactly the best way to put this clearinghouse into place.

And not all derivatives will be subject to the law. The Securities and Exchange Commission and the Commodity Futures Trading Commission approved a rule that would exempt some energy companies, hedge funds and banks from derivative oversight.

How are insurance companies affected by Dodd-Frank?

The law created a new Federal Insurance Office (FIO) under the Treasury Department, which would identify insurance companies, like AIG, that create risk to the entire system.

AIG was caught in in a major liquidity crisis when its credit ratings were downgraded in September 2008. The U.S. Federal Reserve Bank had to step in and create an $85 billion emergency fund—taxpayer money—to help AIG meet increased financial payouts.

The new FIO will also gather information about the insurance industry and make sure affordable insurance is available to minorities.

Are credit rating agencies regulated by Dodd-Frank?

Yes. Dodd-Frank created an Office of Credit Rating at the Securities and Exchange Commission (SEC) to regulate credit ratings agencies like Moody's and Standard & Poor's.

The agencies were criticized for helping to create the 2008 recession by misleading investors through over-rating derivatives and mortgage-backed securities—and saying the investment tools were worth more than their actual value.

As part of the new rules, the SEC can require agencies to submit their rating systems for review, and can de-certify an agency that gives misleading ratings.

How are consumers protected?

Dodd-Frank created the Consumer Financial Protection Bureau(CFPB), to protect consumers from 'unscrupulous business' practices by banks. The CFPB consolidated a number of existing consumer protection responsibilities in other government agencies.

The CFPB works with regulators in large banks to stop transactions that hurt consumers, such as risky lending. The CFPB also provides consumers with access to 'plain English' information about mortgages and credit scores along with a 24-hour toll-free consumer hotline to report issues with financial services.

The CFPB also oversees credit reporting agencies, credit and debit cards, payday and consumer loans— but not auto loans from dealers.

What is the whistle blower provision?

To help fight corruption and insider trading, the Dodd-Frank Act contains a whistle-blowing provision. Someone with information about security violations can report it to the government for a financial reward.

What is the debate over Dodd-Frank?

For many on Wall Street, Dodd-Frank is seen as an overreaction to the recession of 2008, one that will push investors to the sidelines, burden financial institutions with cumbersome rules, and stop overall economic growth.

Others see it as a way to protect their investors and cut down on unnecessary risk as well as protect consumers.

There are some critics, including a Fed official, who say the regulations don't go far enough to reign in an out-of-control Wall Street bent on taking risks and then being bailed out by public tax dollars.

Those in favor of the bill say that had the rules been in place, the recession might not have happened—while many analysts say that if the markets, Congress, and regulators had just followed the existing rules, the financial collapse could have been avoided.

For now, Dodd-Frank mostly remains a lightning rod—too much regulation for some and not enough for others. Its affect on Wall Street will take some time to measure.