Proposed Financial Regulations Send Stocks Falling

U.S. stocks took a fall on Thursday due to concerns that possible government restrictions on banks' size and activities could lead to the unintended consequence of reduced liquidity across the markets.

"We're free falling," said Dave Rovelli, managing director of U.S. equity trading at Canaccord Adams. "People are nervous that Obama's taking his focus from health care on to Wall Street. You start to regulate Wall Street and investors get spooked."

The Dow Jones Industrial Average's financial stocks led its declines, with the likes of J.P. Morgan (NYSE: JPM) and Bank of America (NYSE: BAC) falling in anticipation of new regulations that could change the face of each company.

The financial sector wasn't the only one hit by the news. The shares of companies like Caterpillar Inc. (NYSE: CAT) and Alcoa Inc (NYSE: AA) were also sent tumbling.

If the big banks are forced to limit their activities and reduce their risk, it will lead to reduced liquidity and make it more difficult to raise capital in all sectors.

"It's thought that even if there's not a strict edict from Washington to stop proprietary trading, there might be a move among some of the financial players to rein in some of their leverage and operations so they can fly below the radar screen," said Nick Kalivas, strategist and vice president of financial research at MF Global. "So you could have less liquidity and there's concern it could cause them to cut down on lending."

Kalivas added, "we securitize so much stuff these days that trading activity is important to finding liquidity and finding buyers for a lot of these products. It seems like the administration wants to operate in a 1960s world in 2010. That could mean a reduction in banks' ability to lend as a result of these policies."

It didn't help matters that the proposed changes come as China makes moves to slow its overheated economy.