BOSTON (TheStreet) -- President Barack Obama can no longer be accused of being too diplomatic.

Obama, who had been expected to deliver a slap on the wrist in response to the financial crisis, took a baseball bat to the skull of the banking industry last week. The new stance, if not eventually watered down, would erode the profitability of banks, leading to share-price declines if signed into law.

Obama's proposal comes down to limiting the size of commercial banks and curtailing their activities, notably using Americans' insured deposits to trade for their own accounts, and investing through hedge funds and private-equity funds. Banks had earned billions through so-called proprietary trading and hedge funds, but were up-ended when the credit crunch hit. (In a separate move, Obama wants to assess a "bank tax" to recoup money from the Troubled Asset Relief Program, or TARP.)

Goldman Sachs

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Morgan Stanley

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(JPM) - Get Report



(C) - Get Report


Bank of America

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all stand to be hurt by the proposed regulations. The

S&P 500 Index

last week recorded its biggest three-day decline since March, when the stock-market rally started.

The details on the reform are sketchy, but the abolishment of proprietary trading would be a major blow to banks' profitability. Goldman derives about 10% of its revenue from trading for its own books. JPMorgan and Morgan Stanley have less of their revenue coming from proprietary trading, but even a revenue decrease of a few percentage points in perpetuity alters company valuations on a grand scale.

A troubling detail in the proposal about limiting the size of banks makes for uncertain futures. Presumably, consolidation through mergers and acquisitions among the biggest banks is out of the question. What about growth through excellent performance for their clients? Without the possibility of future growth, investing in banks loses most of its appeal.

Guards against dealing in hedge funds or private equity funds cuts off access to the fastest-growing parts of asset management. (Banks will still be allowed to run asset-management units.) Banks' activities must be "for the benefit of the client," possibly leading to unintended consequences such as proprietary trading being converted into hedge funds with client co-investments.

More likely than not, the ideas brought to the table by Obama won't make it into legislation in a pure form. After seeing health-care reform being slowly neutered while making its way through Congress, the president may have decided to use the nuclear option so that anything that made it to his desk had some actual reform to it.

Clearly, the biggest banks will continue to be massively profitable without proprietary trading since flow-trading operations (trading for clients' benefit) and investment banking generate lots of money. But the Obama administration means business and is looking to take some of the wind out of the sails of the industry.

There's more than enough uncertainty to give the financial sector fits for some time, so investors wanting to ride out a wave of reforms should be ready for big swings based on news items. If the proposal manages to make its way into law in its pure form, there's no telling how drastic the reevaluation of these companies will be. If government works the way it usually does, however, the banks may need little more than some aspirin to recover from this headshot.

-- Reported by David MacDougall in Boston.

Prior to joining Ratings, David MacDougall was an analyst at Cambridge Associates, an investment consulting firm, where he worked with private equity and venture capital funds. He graduated cum laude from Northeastern University with a bachelor's degree in finance and is a Level III CFA candidate.