Obama wants to limit bank size

NEW YORK (CNNMoney.com) -- President Obama on Thursday publicly signed on to a message that former Federal Reserve chief Paul Volcker has been giving for a year: Let's limit the big banks.

Volcker, an economic adviser to Obama, joined the president in announcing new measures to narrow the size and scope of banks' investment activities.

Calling it the "Volcker rule," the president proposed prohibiting commercial banks from making trades for their own accounts. He also proposed prohibiting banks from owning or investing in hedge funds or equity funds.

"We should no longer allow banks to stray too far from their central mission of serving their customers," Obama said in a White House address.

Obama also proposed tougher rules aimed at limiting bank mergers and consolidation. New, yet to be determined, caps would curb banks' marketshare, going further than existing caps.

The proposals are aimed at the nation's largest banks including JPMorgan Chase (JPM, Fortune 500), Citigroup (C, Fortune 500), Bank of America (BAC, Fortune 500), Wells Fargo (WFC, Fortune 500), and Morgan Stanley (MS, Fortune 500) and Goldman Sachs (GS, Fortune 500). Shares of all those banks fell sharply Thursday.

The significance of the announcement is that the new limits, particularly limiting commercial banks' involvement in hedge funds and trading, goes beyond regulatory reform efforts working their way through Congress.

Congress would still have to pass legislation enacting the White House proposal.

"The political climate for the mega banks is getting worse by the day," said Concept Capital Washington Research Group analyst Jaret Seiberg, in a report to clients. "For the mega banks, this is a horrible political position and it is a situation that leads to onerous legislation."

The announcement is somewhat of a reversal for the White House.

Volcker has called for limits to keep commercial banks from wading too deeply in investment banking.

He has said he wants banks to stop owning and trading risky securities to chase big profits, although he believes they should be allowed to underwrite securities for their corporate clients.

According to Volcker, such changes would be "in the spirit" of the Glass-Steagall Act, the now defunct Great Depression era law that put a wall between commercial banks' investment banking operations and their deposits.

Congress repealed Glass-Steagall in 1999. That move helped lead to explosive growth in commercial banks such as giant Citigroup.

Some have said the move to allow banks to wade deeper into the area of investment banking contributed to the financial crisis. Sens. John McCain, R-Ariz., and Maria Cantwell, D-Wash., have filed legislation to re-erect the wall between investment and commercial banking

However, many in the White House, including Obama economic adviser Larry Summers (who was President Clinton's Treasury secretary when Glass-Steagall was repealed), have argued against the case.

On several occasions last year, Summers said he believed the repeal of Glass-Steagall had little or nothing to do with the current financial crisis.

During a June speech, Summers pointed out that many of the financial institutions in trouble were independent investment banks, like Lehman Brothers, Bear Stearns or insurance firms like American International Group. (AIG, Fortune 500) None of those firms would have been impacted by the repeal of Glass-Steagall.

"The lesson that I would draw is much less one of combining banking and investment banking," Summers said at the time. "I suspect it is going to very, very hard -- be very hard -- to put the genie back into the bottle," he added.

The White House proposal announced Thursday is a slightly different take than Glass-Steagall. Regulators would still allow big banks to engage in risky trades for their clients' benefit. They just wouldn't be able to engage in such transactions for their own benefit.

A senior administration official explained that the president decided to propose this next step after watching banks benefit from "special protections" during the crisis and use the extra help to make big profits off their proprietary trading activities.

"This is prohibition that says: 'You can choose to engage in proprietary trading or you can choose to own a bank, but you can't do both,' " the official said.

Obama's proposal was welcomed by congressional Democrats. Senate Banking Committee Chairman Chris Dodd, D-Conn., said in a statement he supported it.

Dodd, whose committee is still working on regulatory reform legislation, attended the White House announcement along with Rep. Barney Frank, D-Mass., chairman of the House Financial Services Committee.

However, banking industry representatives decried the move.

"Trading, proprietary or otherwise, did not lead to the financial crisis," said Rob Nichols, president of the Financial Services Forum, a lobbying group for big bank chief executives.

Steve Bartlett, president of the Financial Services Roundtable, said the proposal would "restrict lending, increase risk, decrease stability in the system, and limit our ability to help create jobs."