If the latest version of financial reform becomes law as expected, banks would lose a lucrative but wildly unpredictable source of profits scaling back so-called alternative investments over the next several years.

It's a bad time to curb what banks can invest in private equity and hedge funds in compliance with the Volcker Rule, observers say.

Private investing earnings are rebounding after plummeting last year; banks need every scrap of income in a post-recession regulatory and economic environment toxic to profit growth.

"My impression is that [alternative investing] is probably a higher return on dollars invested than many of the other bank businesses," said William E. Kelly, a partner with Nixon Peabody LLP who specializes in alternative investing matters. "There is increasing pressure to find profitable products. The private investment funds have been relatively high-margin activities for banks."

It's impossible to get a firm grasp on the impact alternative investing reform could have on banks' bottom lines. Restrictions on certain activities mandated by the compromise bill that the House and Senate agreed to last month may take 10 or more years to take full effect. Lenders are also less than transparent when it comes to disclosing exactly how much they have invested in alternative investment pools.

But regulatory filings nevertheless show that the large banks like JPMorgan Chase & Co. and Bank of America Corp. and regional players like KeyCorp and PNC Financial Services Group Inc. have more exposure to private equity and hedge funds than the bill would allow.

Filings illustrate how rocky — and lucrative — private investing has been for some banks through the years. JPMorgan Chase earned $55 million from private equity in the first quarter, reversing a loss of $280 million a year earlier.

Those number do not include results from JPMorgan Chase's ample hedge fund operations, the most noteworthy of which is its in-house fund, Highbridge Capital Management. Those figures also do not take into account all of the tertiary profits that come from owning and investing in alternative investment funds. The private-equity business, for instance, is notoriously clubby. A bank with a big investment or majority interest in a buyout fund tends to be first in line when it comes to helping that fund line up financing for a deal, advise a merger or underwrite a public offering for a company it owns, among other things.

So the reform bill — by forcing banks to scale back their private investments — has the potential to sap revenue in other advisory and lending services.

Henry Meyer 3rd, the chairman and chief executive of KeyCorp, said in an interview last week that new restrictions on private equity would be "probably the biggest effect" of the reform bill on his $95 billion-asset company.

It earned $37 million in principal investments last quarter, which is not insubstantial given how the company as a whole posted a loss.

"We're not going to be able to [make] any new investments," Meyer said. "Those equity investments help America grow."

Key at March 31 had more than $1 billion in so-called principal investments, a balance sheet line that includes its direct private investments and allocations to outside fund managers. If the financial bill passed and went fully into effect today, Key would be legally permitted to invest up to just about $323 million in hedge funds and private-equity funds.

Meyer said he was not overly "concerned" about the impact of the limit, as the way it is currently structured it would give banks a number of years to comply with the new regulations.

The legislation would hit a bank's alternative investing activities in a few key ways: If a bank owns a hedge fund or private-equity fund, it cannot keep it if it isn't considered part of its core banking business. If the fund is a necessary part of the services it offers, the bank's investment in the fund cannot exceed 3% of all money invested in the fund.

So that means a bank would either have to either spin off a fund, prove that it's a core business or bring on board other investors in order to appease regulators.

The bill would also restrict banks' total alternative investments to just 3% of core capital, which is generally defined as total equity and reserves.

Regulatory filings indicate that JPMorgan Chase, B of A, Key and PNC are all over that limit as of the first quarter with their private-equity investments alone.

Banks would have two years from the date it becomes effective to comply with most of the limits, and can qualify for an extension of up to three years. There is another five-year extension to divest interests in so-called illiquid funds, or assets that cannot be sold quickly.

So banks may have up to 10 years to comply. The lengthy deadline is necessary: Hedge funds generally do not let investors take out their money in less than a year without paying a fee and sacrificing their share of returns. Private-equity funds, which aim to make money buying companies and selling them at a profit, generally have a life of 10 years.

Yet the secondary market for positions in private-equity funds has rebounded in recent months, which was illustrated by reports this week that Citigroup Inc. had agreed to sell about $900 million in unwanted private-equity investments to another party.

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