WASHINGTON—President Barack Obama proposed new limits on the size and activities of the nation's largest banks, pushing a more muscular approach toward regulation that yanked down bank stocks and raised the stakes in his campaign to show he's tough on Wall Street.
With former Federal Reserve Chairman Paul Volcker at his side, Mr. Obama said he wanted to toughen existing limits on the size of financial firms and force them to choose between the protection of the government's safety net and the often-lucrative business of trading for their own accounts or owning hedge funds or private-equity. Mr. Volcker has been an outspoken advocate of such rules; until recently Mr. Obama's top economic advisers, including Treasury Secretary Timothy Geithner and Lawrence Summers, were less than enthusiastic.
"Never again will the American taxpayer be held hostage by a bank that is too big to fail," Mr. Obama said Thursday, two days after voters crimped his ability to pursue his agenda by sending a Republican to the Senate to fill a vacancy created by the death of Edward M. Kennedy. The election deprived Democrats of the 60 votes often needed to get major measures through the Senate.
Administration officials said they weren't trying to resurrect the Depression-era law—known as Glass-Steagall—that strictly divided commercial banks from the business of underwriting securities. Nor would their proposals force existing financial firms to downsize, officials said.
If accepted by Congress, the Obama proposals could force significant changes in how the nation's biggest banks do business.The specter of new profit-crimping regulation battered bank stocks Thursday, dragging down the Dow Jones Industrial Average by 213.27 points, or 2%, to 10398.88. Some financial stocks sank by more than 5%, though they recovered slightly after Barney Frank, the Massachusetts Democrat who is chairman of the House Financial Services Committee, said the new rules would take effect over three to five years, not immediately. J.P. Morgan Chase & Co.'s stock was the hardest hit, sinking 6.6%.
The fate of the Obama proposal is uncertain. The House already has passed a provision that would give regulators new authority to limit the scope and scale of banks. Congressional passage now depends primarily on Senate Republicans. Several Republican senators expressed skepticism about the Obama proposal Thursday. "Let's solve problems," said Arizona Republican Sen. Jon Kyl. "Let's not be finding a bogeyman so that we can turn public attention away from what they're doing wrong in the administration."
But in a political environment decidedly hostile to big banks, Democrats might need only a few Republican votes to enact a variant of what Mr. Obama called "the Volcker rule." Sen. John McCain, the Arizona Republican, said the White House appears to be moving closer to a proposal he is co-sponsoring that would reinstate restrictions on banks that were repealed in the late 1990s. "It seems to me that a number of the proposals [Mr. Obama] has move in that direction," Sen. McCain said, "but I haven't had a chance to examine the details."
Big banks and their trade groups attacked the Obama proposals as unnecessary and unwise. "If people are focused on things that caused or were real contributors to the financial crisis, it wasn't trading," said David Viniar, chief financial officer at Goldman Sachs.
Over the past several years, banks have bulked up their profits in areas far beyond taking deposits, making loans and trading stocks and bonds on behalf of customers.
Some have bought or sponsored hedge funds. Others have moved to invest their own money in the markets.
After the collapse of Lehman Brothers and the rescue of American International Group in the fall of 2008, investment banks Goldman Sachs and Morgan Stanley formally became banks—giving them access to Fed loans and federal guarantees of their borrowing in financial markets.
When the crisis ebbed, Goldman and some other banks were able to borrow at low rates and turn profits trading for their own accounts. This gave Mr. Volcker and his allies, who include Vice President Joseph Biden, new fuel for their argument that government-backed banks should be prevented from taking big trading risks.
"The key issue is that institutions that are getting a backstop from the taxpayer shouldn't be able to make a profit off their own investing," said Austan Goolsbee, a White House economist who staffs the presidential advisory board Mr. Volcker chairs.
Looking Back: Glass-Steagall
Read the Journal's coverage of the early days of the 1933 Glass-Steagall Act, which first walled off commercial banks from investment banks.
Bank executives scrambled Thursday to interpret the proposals, particularly their effect on areas where bank capital is intermingled with client funds. The new rules would, for instance, likely force J.P. Morgan to shed its One Equity Partners private-equity business, which invests the firm's money. Disentangling Goldman's private-equity business, however, could be trickier because it invests its own money in the same funds that clients invest in.
Under the Obama proposal, banks that take federally insured deposits or have the right to borrow from the Fed would be prohibited from owning, investing in or sponsoring hedge funds or private equity firms. "You can choose to engage in proprietary trading, or you can own a bank, but you can't do both," an administration official said.
The president also called for expanding the reach of a 1994 law that forbids banks from acquiring another bank if the deal would give it more than 10% of the nation's insured deposits. He would expand that limit to cover other types of funding—such as bank's short-term borrowing from financial markets—and perhaps put a cap on the share of assets any one firm could hold.
The Thursday announcement is the latest move by the White House to target Wall Street and banks. Earlier this month, the president proposed a new fee on large banks and insurance companies that would raise $90 billion over ten years, ostensibly to offset the costs of the bailout of financial firms and auto giants.—Michael R. Crittenden and Susanne Craig contributed to this article.