While a number of factors led to such a severe recession, the primary cause was a breakdown in our financial system. It was a crisis born of a failure of responsibility from certain corners of Wall Street to the halls of power in Washington. For years, our financial sector was governed by antiquated and poorly enforced rules that allowed some to game the system and take risks that endangered the entire economy.
Unscrupulous lenders locked consumers into complex loans with hidden costs. Firms like AIG placed massive, risky bets with borrowed money. And while the rules left abuse and excess unchecked, they left taxpayers on the hook if a big bank or financial institution ever failed.
--President Barack Obama, from prepared remarks at the signing ceremony for the Dodd-Frank Wall Street Reform and Consumer Protection Act, July 21, 20101
Scholars, practitioners, and casual observers will debate for years to come the precise causes of the 2008 financial crisis. They need not agree with President Obama’s broad description of those causes, however, to understand that it summarizes how legislators perceived those causes in 2009 and 2010, when members of Congress began to craft the Dodd-Frank Act. Through its wide-ranging prescriptions for everything from mortgage lending to shareholder voting to derivatives clearing, and despite the fact that few congressional Republicans supported it, Dodd-Frank reveals where Congress saw flaws in the US financial system.
On the day he signed Dodd-Frank into law, President Obama tried to distill some of those flaws and place them into a few broad categories. First, he described inadequate prudential supervision and regulation, noting how “our financial sector was governed by antiquated and poorly enforced rules that allowed some to game the system and take risks that endangered the entire economy.” Second, he referred to bailouts, those government loans, payments or guaranties that “left taxpayers on the hook if a big bank or financial institution ever failed.” Finally, he cited consumers’ vulnerability to sharp practices, such as when “lenders locked consumers into complex loans with hidden costs.” These broad categories offer a simple but useful way to consider Dodd-Frank and its responses to the crisis.
“Antiquated and poorly enforced rules.” Rulemaking, on-the-ground examination and inspection, and enforcement actions are the ways regulatory agencies make sure financial institutions operate safely and soundly. The financial crisis revealed how these activities, generally referred to as prudential supervision and regulation, sometimes failed to keep up with innovations in the financial marketplace or financial institutions’ reckless behaviors. As evidence, some members of Congress pointed to eroded mortgage lending standards, others to unchecked and opaque securitization, still others to deregulation and the mingling of traditional banking and securities investment. Many cited all of the above and then some. Congress didn’t hesitate to hold the regulatory agencies responsible, either, whether because these watchdogs didn’t appreciate the severity of the problems afflicting the residential housing market, failed to rein in the securities market, or allowed financial institutions to carry too little capital and too much debt.
Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 929-Z, 124 Stat. 1376, 1871 (2010).
Written as of November 22, 2013. See disclaimer.