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As Dave covered yesterday, Paul Volcker finally emerged from his (large) broom closet in the White House as the major force behind Obama's new banking sector reforms. To recap, the US president proposed two new reforms to end 'too big to fail' and limit the proprietary trading operations of banks. His proposals will: 1) prohibit banks from owning, sponsoring or investing hedge funds, private equity funds or proprietary trading operations for their own profit, unrelated to servicing their customers- the so-called 'Volcker Rule;' and 2) prevent the further consolidation of the financial industry.

On the surface these reforms mark a dramatic departure from the administration's standing approach to financial sector reform (fairly benign). But before we get ahead of ourselves with excitement, it is important to recognize the considerable obstacles to these proposals ever becoming law, and examine whether what sounds good in theory is actually inadequate in practice. A few thoughts:

-Obviously we are a bit light on the very critical details. For instance, how exactly will the administration prevent further consolidation in the industry, or end 'too big to fail' as we know it? By limiting the size of individual firms through a cap on assets under management or deposits? Or by applying robust anti-trust scrutiny to any future mergers and acquisitions of financial firms? It seems the administration has collapsed two very different and tricky issues into one concept: limiting systemic risk. You can cap a bank's size, and therefore risk to the system, through higher capital adequacy requirements, but this doesn't address the off-balance sheet activities that were the real systemic threat during the crisis. You might reply that the Volcker Rule would largely resolve the off-balance sheet problem, but it seems the administration has very consciously linked the prohibition on these activities to the prevailing bank-holding company model. Remember, all the big investment banks converted into bank-holding companies during the crisis to access Fed funding, which then entailed setting up retail banking, or deposit-taking, operations. Under the Volcker Rule, these banks would now be unable to de-link retail and trading operations, even conceptually, thus prohibiting every major bank from engaging in proprietary trading unrelated to traditional brokerage (think boring mutual funds instead of exotic securities). There goes almost ALL the profit-making activities the banks currently have.

But what if banks like Goldman Sachs and Morgan Stanley simply converted into a different legal entity once they no longer relied on easy Fed funding for their trading operations? By ditching the small retail operations they have built, they could theoretically return to the old model once they are self-sustainable, thereby bypassing the Volcker Rule all together. This would put banks with huge depository operations like JPMorgan Chase and Bank of America at a competitive disadvantage. Everyone joked before the crisis that Goldman Sachs was the biggest hedge fund in the world: what prevents them from becoming something like an alternative asset management firm? It's customers would in theory possess a higher risk-tolerance and proprietary trading operations could be justified on serving this investor profile. Without formally resurrecting Glass-Steagall, which doesn't appear to be on the table, I am unclear how the administration can put in place a regulatory apparatus that stays two-steps ahead of financial and legal innovation.

-These reforms are an important step in the right direction, but they are also blatantly political, which makes them vulnerable on a number of levels. The administration is claiming that the proposals have been under serious discussion for months, they just needed to be refined and introduced at the appropriate time. This is plausible, as they were proposed on the very day that health care reform 'died.' The administration may have simply been planning a big financial reform push following health care's conclusion, which they expected this month. And surely the posture of bank execs before Congress last week, not to mention record bonus announcements, didn't do themselves or their industry any favors. 'Keep it cool' Obama seems genuinely furious.

But its timing on the heels of the Massachusetts primary in which a Republican candidate won the seat held by Ted Kennedy for four decades smacks of calculated populism. The FT said as much in its editorial. This leaves it subject to political horse-trading, both within Congress and between legislators and the administration. Could it become a bargaining chip in preserving the controversial consumer financial protection agency, Obama's centerpiece reform? Obama could pick off a few Republican supporters for the banking proposals; John McCain has expressed some similar sentiments recently, and the issue taps right into the anti-Wall Street fervor that shows no signs of abating. But he could also lose votes on his side, like Joe Lieberman or the chairman-in-waiting of the Senate Banking Committee Tim Johnson, who is a 'friend' of the financial services industry, to put it diplomatically. If financial reform gets held up until after the mid-terms (when Chris Dodd, current chairman of the Senate Banking Committee, retires) a Johnson chairmanship could pose real problems for the administration.

-Finally, let's say that the reforms get enacted in some form or another. The big winners are then the hedge fund and private equity industries. A lot of people predicted that they would increasingly fill the risk-taking space vacated by the big banks. But with Goldman trading the daylights out of essentially free loans from the Fed, the current status-quo retains plenty of risk-taking in the big institutions. But if prop desks are truly scaled down at these firms, suddenly hedge funds become the major traders in a range of instruments and markets, providing a goldmine to the industry. This raises a whole host of unresolved problems, including systemic risk considerations (remember Long Term Capital Management?). Reform of the hedge fund industry has proven surprisingly difficult in Europe, and limited reforms have thus far been proposed in the US.

So in conclusion, I am left with two basic questions: will the reforms be precise enough to achieve their objectives in an innovative marketplace, and what are the most effective tools in limiting the systemic risk posed by individual firms? I'm eager to see the details of the proposals.