Banking reform: Harder than it sounds

WASHINGTON (Fortune) -- It took long enough, but with his proposal to break up the banks, President Obama has finally presented a way to reform Wall Street that matches the scale of the problem.

No more nibbling around the edges by adding regulators -- the president is going straight after the "too big to fail" issue, and if Congress agrees with his proposal, the banks may realize, at long last, how much they've messed up in Washington.

The central idea of Obama's proposal is fairly easy to grasp: Separate a bank's riskiest operations from the parts that are vital to the economy functioning, like deposits and loans to individuals and businesses. Banks that hold federally insured deposits or borrow from the Fed would no longer be able to use any of those funds to gamble in the financial markets. The days of in-house hedge funds and buyout firms would be over.

The trouble lies in figuring out how this will all work in practice. Critics say the intentions here are good, but the dividing line between commercial banking and risky proprietary trading can be harder to spot than you would think.

"In commercial banking you make loans. In investment banking you deal with securities," says Doug Elliott, a fellow at the Brookings Institution and former investment banker. "The thing is, loans have become instruments that are pretty fairly traded. You can't tell me the characteristics of a loan that makes it different from a security."

Elliott also points out in a recent paper that banks in some ways serve their customers better by maximizing returns on their money, as a matter of simple liquidity management. What looks risky to one person is a necessary business practice to someone else.

The other question is whether "Volcker's rule"-- named after Paul Volcker, the widely-respected former Fed chair who has been the idea's lonely champion for months -- could have prevented the most recent crisis.

Skeptics say the credit crisis wasn't spawned by the bank's in-house hedge funds and private equity funds. It was bad loans, plain and simple, which were then compounded by over-the-counter derivatives and credit default swaps. Whether or not the bank also had a proprietary trading arm would not have made a difference.

Regardless of the details, which the White House and Congress will have to hammer out in coming months, the banks have completely misjudged Washington. Wall Street has waded into the worst possible political environment in which to put up a fight: The health care debacle has led the Democrats to cast about for a more popular issue to adopt, and in this economy, nothing could be more obvious than going after Wall Street.

Republicans have thus far proven their uncanny ability to oppose everything supported by the Democrats, but it will be a stretch for them to ally themselves with bank CEOs. And Obama knows it. As he said yesterday, "If these folks want a fight, it's a fight I'm ready to have."

And of course, the banks have done themselves no favors in Washington with their recent performances, with next to no displays of contrition. At last week's hearings on the Hill before the Federal Crisis Inquiry Commission, some observers thought they heard Goldman Sachs (GS, Fortune 500) CEO Lloyd Blankfein admit the bank had behaved in an "improper" way.

Not so, says the bank, which released this tortured statement: "Mr. Blankfein was responding to a lengthy series of statements followed by a question that was predicated on the assumption that a firm was selling a product that it thought was going to default. Mr. Blankfein agreed that, if such an assumption was true, the practice would be improper. Mr. Blankfein does not believe, nor did he say, that Goldman Sachs had behaved improperly in any way."

At that same hearing, Blankfein talked repeatedly about improving risk management at his bank. And yet by clinging to their bonuses (deserved or not), Wall Street yet again chased the short-run money over the long-run. By the time the White House and Congress are done with this reform bill, the banks will regret how dearly they held onto their profits.