Table of Contents
SERIES 7 | SERIES 65 | FINANCIAL REGULATION COURSES
The Dodd-Frank Wall Street Reform and Consumer Protection Act — universally known as the Dodd-Frank Act and formally designated Public Law 111-203 — is the most sweeping and comprehensive reform of the United States financial regulatory framework since the Banking Act of 1933 and the Securities Exchange Act of 1934 enacted in the immediate aftermath of the Great Depression, signed into law by President Barack Obama on July 21, 2010, in direct legislative response to the financial crisis of 2007 through 2009 — the worst economic catastrophe since the Great Depression — which exposed fundamental failures in the regulation of financial institutions, derivatives markets, consumer financial products, and the securitisation infrastructure that collectively created the conditions for systemic financial collapse requiring extraordinary government intervention to prevent.
Named for its principal sponsors — Senator Christopher Dodd of Connecticut, then chairman of the Senate Banking Committee, and Representative Barney Frank of Massachusetts, then chairman of the House Financial Services Committee — the Act spans 848 pages of statutory text and more than 2,300 pages when combined with the implementing regulations subsequently adopted by the SEC, CFTC, Federal Reserve, FDIC, OCC, CFPB, and other regulatory agencies charged with translating the Act's mandates into enforceable rules.
The Dodd-Frank Act is directly tested on the Series 7 and Series 65 examinations in the context of financial regulation, derivatives regulation, consumer protection, systemic risk oversight, the swaps regulatory framework, the Volcker Rule, the risk retention requirement for asset-backed securities, Regulation Best Interest, and the creation of the Consumer Financial Protection Bureau — making comprehensive understanding of the Act's major provisions essential knowledge for any securities industry professional.
The financial crisis of 2007 through 2009 originated in the collapse of the United States residential housing market and the proliferation of complex mortgage-related structured financial products — subprime residential mortgage-backed securities and collateralised debt obligations backed by pools of such securities — whose true credit risks had been systematically obscured by flawed rating agency methodologies, misaligned originator incentives, inadequate investor due diligence, and regulatory gaps that allowed a largely unregulated shadow banking system to accumulate enormous concentrated exposures to housing market deterioration.
The crisis produced a cascading sequence of institutional failures beginning with the collapse of two Bear Stearns hedge funds in June 2007 and culminating in the September 2008 failures of Lehman Brothers and the near-simultaneous government rescue of American International Group — whose Financial Products division had written hundreds of billions of dollars of credit default swap protection on mortgage-related securities without adequate capital to honour those commitments when the protected securities collapsed in value. The government interventions of September and October 2008 — including the Federal Housing Finance Agency's conservatorship of Fannie Mae and Freddie Mac, the Treasury Department's rescue of AIG, the establishment of the Troubled Asset Relief Programme, and the Federal Reserve's extraordinary liquidity facilities — together prevented a complete collapse of the global financial system but required commitments of federal resources measured in the trillions of dollars.
Congress determined that the crisis had been enabled by a combination of inadequate systemic risk oversight — no single regulator was responsible for monitoring the risks accumulating across the interconnected financial system — regulatory gaps that allowed significant financial activity in the shadow banking system and derivatives markets to proceed without meaningful oversight — misaligned incentive structures in consumer lending and securitisation that rewarded loan origination volume rather than loan quality — and inadequate consumer protection from abusive financial practices. The Dodd-Frank Act addressed each of these failures through a comprehensive legislative programme spanning sixteen distinct titles.
Title I of the Dodd-Frank Act addresses the systemic risk oversight failure by creating the Financial Stability Oversight Council — the FSOC — a new interagency body chaired by the Secretary of the Treasury and composed of the heads of the principal federal financial regulatory agencies, charged with identifying threats to the stability of the United States financial system and coordinating the regulatory responses to those threats across the multiple agencies with jurisdiction over different segments of the financial system.
The FSOC has the authority to designate nonbank financial companies as systemically important financial institutions — SIFIs — subjecting them to enhanced prudential supervision by the Federal Reserve even if they are not bank holding companies. This designation authority was designed to address the regulatory gap that had allowed systemically important nonbank financial firms — including AIG, GE Capital, and the major broker-dealers — to operate without the heightened capital, liquidity, and risk management requirements applicable to bank holding companies, despite posing equivalent or greater systemic risks.
Title I also established the Office of Financial Research within the Treasury Department to support the FSOC by collecting, standardising, and analysing financial data from across the financial system — creating the information infrastructure needed to identify systemic risk concentrations that no single regulatory agency could observe within its own jurisdiction.
Title II of the Dodd-Frank Act addressed the too-big-to-fail problem — the implicit understanding that the federal government would rescue the largest and most interconnected financial institutions rather than allow their disorderly failure to cascade through the financial system — by creating the Orderly Liquidation Authority, which grants the FDIC the power to resolve failing systemically important financial institutions through an orderly wind-down process that protects the financial system without protecting the failing institution's shareholders and senior management.
The Orderly Liquidation Authority was designed to eliminate the expectation of government bailout that had created moral hazard — the incentive for large financial institutions to take excessive risks in the knowledge that their systemic importance would compel government rescue if those risks produced losses. By providing a credible alternative to bailout, the OLA was intended to harden the market discipline that had previously been undermined by too-big-to-fail expectations.
Title VII of the Dodd-Frank Act is the most technically complex and most directly examined provision of the Act in the securities licensing examination curriculum — creating the comprehensive regulatory framework for the over-the-counter derivatives market that had previously operated largely without federal oversight. The over-the-counter swaps market — including interest rate swaps, credit default swaps, currency swaps, and equity swaps — had grown to notional values exceeding several hundred trillion dollars by 2008 with essentially no mandatory clearing, reporting, or margin requirements, creating the concentrated bilateral counterparty exposures that amplified the financial crisis when AIG's credit default swap portfolio became the mechanism of systemic contagion.
Title VII divided regulatory jurisdiction over the swaps market between the CFTC — which assumed jurisdiction over most swap types including interest rate swaps, currency swaps, and most credit default swaps — and the SEC — which assumed jurisdiction over security-based swaps defined as swaps referencing a single security, loan, or narrow-based index of securities.
The four foundational requirements of the Title VII swaps framework apply to standardised swaps and are the most examination-tested provisions. Mandatory central clearing requires standardised swaps to be submitted for clearing through registered derivatives clearing organisations — interposing a central counterparty between every buyer and seller to eliminate bilateral counterparty risk. Mandatory exchange trading or swap execution facility trading requires that cleared swaps be executed on regulated trading platforms that provide pre-trade price transparency rather than through the opaque bilateral telephone negotiation that characterised the pre-crisis market. Mandatory reporting to swap data repositories requires that all swap transactions — both cleared and uncleared — be reported to registered repositories providing regulators with comprehensive visibility into derivatives market activity. Margin requirements for uncleared bilateral swaps require that counterparties to swaps not submitted for central clearing post initial margin and variation margin to third-party custodians reducing bilateral counterparty credit risk.
The Title VII framework specifically addresses the AIG failure by requiring that swap dealers — the major financial institutions that act as market makers in the swaps market — register with the CFTC or SEC and comply with capital, margin, business conduct, recordkeeping, and reporting requirements designed to ensure their financial soundness and market conduct integrity.
Title IX of the Dodd-Frank Act contains the investor protection provisions most directly relevant to the securities industry and most extensively tested in the Series 7 and Series 65 examinations.
Section 913 of the Act directed the SEC to study the existing standards of conduct applicable to broker-dealers and investment advisers and to adopt rules imposing a uniform fiduciary standard on broker-dealers who provide personalised investment advice to retail customers if the SEC determined such rules were necessary and appropriate. The SEC ultimately responded to this mandate not by imposing a full fiduciary standard on broker-dealers but by adopting Regulation Best Interest — codified at 17 CFR 240.15l-1 and effective June 30, 2020 — which imposes a best interest obligation on broker-dealers recommending securities transactions or investment strategies to retail customers. Regulation Best Interest requires broker-dealers to act in the retail customer's best interest without placing the broker-dealer's own financial interest ahead of the customer's — a standard higher than the suitability obligation of FINRA Rule 2111 but not identical to the full fiduciary duty applicable to investment advisers under the Investment Advisers Act of 1940.
Section 929X of Title IX required the SEC to adopt rules implementing enhanced enforcement powers and whistleblower protections — creating the SEC Whistleblower Programme under which individuals who provide original information about securities law violations that leads to successful enforcement actions may receive between ten and thirty percent of sanctions collected above one million dollars.
Title IX also strengthened the regulation of credit rating agencies — responding to the central role played by inflated credit ratings on mortgage-related structured securities in the financial crisis — by increasing the SEC's oversight authority over nationally recognised statistical rating organisations and imposing requirements for rating methodology transparency, management of conflicts of interest, and accountability for materially incorrect ratings.
Section 941 of the Dodd-Frank Act added Section 15G to the Securities Exchange Act of 1934, requiring securitisers of asset-backed securities to retain not less than five percent of the credit risk of the assets they securitise — the skin-in-the-game requirement directly addressing the originate-to-distribute incentive misalignment identified as a root cause of the financial crisis.
The joint final rule implementing the risk retention requirement — adopted by the SEC, Federal Reserve, FDIC, OCC, FHFA, and HUD — became effective for residential mortgage-backed securities on December 24, 2015 and for other asset-backed securities on December 24, 2016. The rule permits retention through a horizontal first-loss position in the most junior tranche of the securitisation, a vertical slice of five percent of each tranche, or a combination of the two — as long as the securitiser is prohibited from directly or indirectly hedging away the retained credit risk.
The Volcker Rule — named for former Federal Reserve Chairman Paul Volcker who proposed the underlying concept — is the provision of the Dodd-Frank Act most commonly associated in public discourse with restrictions on bank risk-taking. Codified in Section 619 of the Act and implemented through coordinated rules of the Federal Reserve, OCC, FDIC, SEC, and CFTC, the Volcker Rule prohibits banking entities — including bank holding companies and their subsidiaries — from engaging in proprietary trading for their own accounts and from owning, sponsoring, or investing in hedge funds or private equity funds beyond specified limits.
The rationale for the Volcker Rule is the moral hazard created when institutions with access to federal deposit insurance and Federal Reserve liquidity support engage in speculative trading for their own profit — using the implicit government backstop of their banking franchise to underwrite speculative risks that belong in uninsured capital market institutions. The Volcker Rule was designed to separate the protected banking system from the proprietary risk-taking that characterises hedge funds and proprietary trading desks.
The Volcker Rule includes important exceptions for market making in securities — allowing banking entities to hold securities inventory in connection with providing liquidity services to customers — and for risk-mitigating hedging — allowing positions that demonstrably reduce the entity's own risks rather than speculating on market movements. These exceptions have been the subject of extensive regulatory guidance and ongoing refinement since the rule's original implementation.
Title X of the Dodd-Frank Act created the Consumer Financial Protection Bureau — the CFPB — as an independent bureau within the Federal Reserve System with exclusive authority to write and enforce consumer financial protection rules applicable to a wide range of financial products and services including mortgages, student loans, credit cards, auto loans, payday loans, and other consumer credit products.
The CFPB consolidated consumer financial protection functions previously scattered among seven different federal regulatory agencies — the Federal Reserve, OCC, OTS, FDIC, NCUA, HUD, and FTC — into a single focused agency whose sole mission is consumer protection rather than safety and soundness. The Director of the CFPB is appointed by the President and confirmed by the Senate with for-cause removal protection — a governance structure whose constitutionality was confirmed by the Supreme Court in Seila Law LLC v. Consumer Financial Protection Bureau in 2020 after the Court severed the for-cause removal protection as unconstitutional in a manner analogous to the Free Enterprise Fund v. PCAOB decision regarding the PCAOB.
The CFPB's most consequential regulatory actions in the securities examination context include the Ability-to-Repay and Qualified Mortgage rule implementing the mortgage standards of the Dodd-Frank Act and the various rules governing the disclosure and conduct standards applicable to consumer financial products under the Truth in Lending Act as amended by Dodd-Frank.
The Dodd-Frank Act is tested on the Series 7 and Series 65 examinations across multiple contexts — derivatives regulation, investor protection standards, systemic risk oversight, asset-backed securities risk retention, the Volcker Rule, and the CFPB.
The key points to retain are these.
The Dodd-Frank Wall Street Reform and Consumer Protection Act — Public Law 111-203 — was signed by President Obama on July 21, 2010 as the comprehensive legislative response to the 2007 through 2009 financial crisis. It is named for Senator Christopher Dodd and Representative Barney Frank.
Title I created the Financial Stability Oversight Council — FSOC — to identify systemic threats and designate nonbank SIFIs for enhanced Federal Reserve supervision, and the Office of Financial Research to support the FSOC with system-wide data. Title II created the Orderly Liquidation Authority giving the FDIC power to resolve failing systemically important institutions without bailout. Title VI — the Volcker Rule — prohibits banking entities from proprietary trading and from owning hedge funds or private equity funds beyond specified limits.
Title VII created the comprehensive swaps regulatory framework — mandatory central clearing of standardised swaps through registered derivatives clearing organisations, mandatory swap execution facility or exchange trading, mandatory reporting to swap data repositories, and margin requirements for uncleared bilateral swaps — dividing jurisdiction between the CFTC for most swaps and the SEC for security-based swaps. Section 913 of Title IX directed the SEC to study the broker-dealer conduct standard — leading ultimately to the adoption of Regulation Best Interest at 17 CFR 240.15l-1 effective June 30, 2020. Section 941 added Securities Exchange Act Section 15G requiring securitisers to retain five percent of credit risk — effective December 24, 2016 for non-mortgage asset-backed securities. Title X created the Consumer Financial Protection Bureau as an independent bureau within the Federal Reserve with exclusive consumer financial protection rulemaking and enforcement authority — the CFPB's key actions include the Ability-to-Repay and Qualified Mortgage rule governing residential mortgage standards.
