Annual Report 2010

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Framework for Regulatory Reform

The Dodd-Frank Act represents the most far-reaching reform of financial regulation in the post-World War II era. Its provisions address a number of the most critical sources of vulnerability in the financial system.

First, the Act expands on the traditional view that a principal source of fragility in the financial system is highly leveraged institutions borrowing short-term to fund investments in risky term loans and securities. Before the crisis, regulation focused on addressing these risks in banks and other depository institutions. However, the financial crisis demonstrated that these vulnerabilities were present in a wide range of financial instruments, structures, institutions, and markets. The Act enlarged the umbrella for rigorous prudential oversight well beyond depository institutions to include all financial sector segments that pose systemic risks.

Second, the Act calls for what is known as a macroprudential supervisory framework. The more traditional microprudential approach to supervision focuses on ensuring the financial soundness of individual institutions. In contrast, macroprudential supervision takes into account risks to the financial system as a whole. These risks arise from the direct interconnections among large financial institutions, as well as similarities in their investments and sources of funding. The other dimension of macroprudential policy involves monitoring and responding to market-wide developments to guard against excesses and stresses that threaten the stability of the financial system.

Third, the Act closes a gap in financial supervision uncovered by the financial crisis—the limited scope that authorities had for dealing promptly with certain types of institutions under stress, such as large investment banks and insurance companies that play significant roles in the financial system. The new law fills this gap by giving federal agencies expanded resolution authority, which allows them to exert control over systemically important financial institutions that are in danger of failing.

Fourth, the Act addresses the need to better protect borrowers, a need underscored by the extremely high mortgage delinquency and foreclosure rates of recent years. To accomplish this, the Act created the Consumer Financial Protection Bureau.

Implementing the Dodd-Frank Act

The Dodd-Frank Act contains hundreds of provisions designed to strengthen the nation’s financial system in three key areas: financial stability, prudential supervision, and consumer protection. The Federal Reserve has significant responsibility for implementing many of these provisions, particularly in its banking supervision and economic research functions. In addition, the Dodd-Frank Act expands the Federal Reserve’s supervisory authority to include all savings and loan holding companies and nonbank financial institutions designated as systemically important.

These developments reinforce the longstanding mission of the Federal Reserve’s banking supervision and regulation function to promote a safe, sound, and stable banking and financial system that supports the growth of the U.S. economy.