So, wow, the Obama administration has reacted very quickly — perhaps too quickly — post the Massachusetts Senate election. After proposing a tax on bank liabilities, Obama is taking an even tougher line, adopting recommendations from Paul Volcker that banks be limited in their size and scope.

Before getting to specifics, it’s worth noting how Geithner and Summers appear to have lost favor. In the preamble to the proposal, Obama mentions neither of them. And when he announced the plan he did so with Volcker and Bill Donaldson standing behind him…Geithner and Summers were off to the side. Could the duo be headed for the exit?

But back to the proposals themselves. Unfortunately they are very vague:

1. Limit the Scope – The President and his economic team will work with Congress to ensure that no bank or financial institution that contains a bank will own, invest in or sponsor a hedge fund or a private equity fund, or proprietary trading operations unrelated to serving customers for its own profit.

In his prepared remarks, Obama called this first proposal the “Volcker Rule,”

2. Limit the Size – The President also announced a new proposal to limit the consolidation of our financial sector. The President’s proposal will place broader limits on the excessive growth of the market share of liabilities at the largest financial firms, to supplement existing caps on the market share of deposits.

These are good ideas, but until we see the details it’s hard to offer unconditional support.

The idea behind the first proposal is that since government insures bank liabilities, it must control bank assets. Bank liabilities are insured explicitly via deposit insurance and implicitly, for the biggest banks, via a general too-big-to-fail guarantee. Deposit insurance is the only one of those two that is defensible and its purpose is to protect the integrity of the payments system. Currently banks use this insurance to obtain cheap funding that supports risky side businesses, like proprietary trading.

But how will prop trading be defined? Will banks actually have to split up? Will they merely have to tweak their corporate structure?

As for the proposal regarding bank size, it doesn’t appear that there will be much to it. Banks won’t have to get smaller or even stop growing. Instead the new rules will just prevent bigger banks from making (any?) acquisitions. They’ll be able to continue growing organically. This probably isn’t enough to reduce systemic risk, unless other reforms can successfully reduce risk-taking. (Personally I think we should break up the banks into baby banks the way we busted AT&T into baby bells….so that none is so large as to be impossible to resolve in a crisis.)

It looks a little clumsy, putting out a plan this short on detail. That said, it seems to mark a clean break with the ridiculous policy that somehow protecting the banks protects America.

The real test for Obama’s leadership, by the way, will probably come if a substantive plan like this passes. Forcing banks to make big changes to their balance sheets will surely crimp the economy in the short-run as it makes it more difficult for banks to extend credit.

That’s not a bad thing. Either we do it proactively in order to contain risk, or we let the system blow itself up again. The latter course will lead to more credit destruction of course. But asking people to voluntarily subject to economic pain will be tough. Hopefully Obama sticks to his guns.