U.S. stocks dropped on Thursday as President Barack Obama took a tough stance on financial institutions, proposing rules to make the system safer by preventing the biggest banks from taking excessive risks.

The Dow fell 2 percent, while the S&P 500 and Nasdaq were each down more than 1 percent immediately after Obama's announcement. Major banks slid, with Goldman Sachs falling 3.7 percent to $161.68 after earlier dropping more than 5 percent despite posting stronger-than-expected fourth-quarter results.

Obama said banks should no longer be allowed to own, sponsor or invest in hedge funds for proprietary profit. Proprietary trading -- when a firm uses its own money to make bets on markets -- has been an engine of earnings for some major banks.

If you look at bank earnings over the last few years, what some of the more astute banks have been able to do is to smooth (out) their earnings using trading activity, said Subodh Kumar, chief investment strategist at Subodh Kumar & Associates in Toronto.

Presumably this (proposal) is going to hold that down. So the ability to generate revenues just by trading on their own accounts is going to go down.

The Dow Jones industrial average <.DJI> was down 218.56 points, or 2.06 percent, at 10,384.59. The Standard & Poor's 500 Index <.SPX> was down 21.07 points, or 1.85 percent, at 1,116.97. The Nasdaq Composite Index <.IXIC> was down 23.29 points, or 1.02 percent, at 2,267.96.

In other markets, the dollar fell and bonds rose in a flight to safety as the stock market tumbled on Obama's announcement.

Citigroup fell 4 percent to $3.32, JPMorgan Chase & Co shed 4 percent to $41.43 and Bank of America dropped 4 percent to $15.83.

The Select Sector SPDR Financial ETF was down 1.5 percent.

Also contributing to Wall Street's slide were major energy companies whose shares fell as oil prices dropped 1.6 percent to $76.08 a barrel.

Exxon Mobil shares were down 1.7 percent at $66.85. Chevron Corp fell 1.9 percent to $76.63.

The CBOE Volatility index <.VIX>, sometimes called Wall Street's fear gauge, jumped as investors turned cautious after the proposed restrictions on U.S. banks.

The VIX was up about 14 percent at 21.36 and was on track to post its biggest two-day percentage gain in 13 months.

(Editing by Kenneth Barry)