WASHINGTON — A plan to raise capital standards at both small and large banks could potentially hamper the legislative effort to break up the biggest institutions, industry observers warned after the unauthorized leak of draft legislation late last week.

The draft bill, authored by Sens. Sherrod Brown, D-Ohio, and David Vitter, R-La., would scrap proposed Basel III requirements and replace them with a 10% capital standard for all institutions, along with an additional 5% for institutions with more than $400 billion of assets. While many small banks have been supportive of the effort to break up the big banks, they are likely to oppose the legislation if such a provision is included in the final bill, observers said.

"This effort was facing long odds to begin with, but without community banks being very vocal in support of it, I doubt it will even see the light of day outside of the Senate Banking Committee," said Isaac Boltansky, a policy analyst at Compass Point Research & Trading.

Yet others said Brown and Vitter may be persuaded to lower the 10% requirement in order to secure small bank support.

"On the face of it, small bankers aren't going to like higher capital standards either. But at the end of the day I think community bankers could support this legislation, though they might try and ask allies to offer amendments to exempt or move the cutoff amount around," said Brandon Barford, a vice president at ACG Analytics.

To be sure, the bill has yet to be formally introduced, and its ultimate makeup may be different. A spokesman for Vitter declined to comment on how much the bill's language could change from the draft plan, but said that the leak was designed as an attack on the pending legislation.

"A Wall Street-friendly lobbyist stole and distributed a copy of our draft bill to try and drum up support for protecting the big banks' taxpayer funded handouts — and ultimately remain too-big-to-fail," said Luke Bolar, Vitter's spokesman.

A spokeswoman for Brown declined to comment.

Still, for now at least, the draft bill offered industry representatives their best peek yet on what Vitter and Brown are considering. Some said the capital requirements contemplated in the bill are simply too high.

"If they put those excessively high capital levels, that will certainly impact lending and credit availability," said one senior industry official, reacting to the draft proposal's 15% requirement for the largest institutions. "Obviously, capital is one of many tools to address the safety and soundness of the financial markets, but it's not the only tool. If you keep ratcheting up the capital requirement higher and higher, at some point you're going to see a drag on growth."

Yet their concerns went beyond proposed capital standards and touched on other parts of the draft bill.

"The guidance on the legislation had largely been that it would increase capital standards for the nation's largest banks and that that would be the primary thrust of the legislative effort," said Boltansky. "But after reviewing the language it appears to be taking a broader approach to setting new capital requirements, as well as instituting new checks on systemic risk."

For example, the plan would put restrictions on certain affiliate transactions, "which really read as an attempt to reinstate elements of the Glass-Steagall Act," Boltansky added. "The bill includes very stringent prohibitions on transfers, loans or financial support from a depository institution to a non-depository affiliate, which came as somewhat as a surprise."

Jaret Seiberg, an analyst at Guggenheim Securities, pointed to a key provision focused on how much capital banks would have to hold in the absence of regulatory safety nets.

"We believe the key innovation in this bill is the focus on how much capital banks would have to hold if the Federal Reserve, [Federal Deposit Insurance Corporation] insurance and the federal income tax did not exist," said Seiberg in a note to clients on Monday. "What we believe the senators are trying to do is to identify a capital level that depositors would have demanded before all these government distortions."

He added: "To us, this is material as it creates an end-corporate-subsidy argument to the broader break-up-the-banks mantra. In effect, this argues that banks are only able to operate with such low capital levels because the government created a safety net backed by taxpayers. So the correct policy choice is not to eliminate that safety net — as it may create economic instability — but to force these banks to act as if these benefits did not exist."

The Brown-Vitter effort has gained significant momentum in the past few months amid concerns that large institutions are both "too big to fail" and "too big to jail."

Still, analysts continue to believe that passage of any bill is unlikely in the short term barring another banking scandal that could fuel more support.

"I don't get the sense that anyone, even its sponsors, believed that this was a piece of legislation that was going to be moving immediately," said a second industry official.

Indeed, several observers noted that the legislation, both the draft plan and whatever Brown and Vitter eventually introduce, are simply pieces of the growing discussion around concerns over "too big to fail."

"To us, Brown-Vitter is the next building block in the creation of a legislative foundation to eventually tackle the too-big-to-fail issue. One must combine it with the SAFE Act, the Vitter budget amendment to eliminate too-big-to-fail subsidies, Sen. Sander's bill to have regulators break up systemic banks, and Federal Reserve Gov. Tarullo's push to limit bank liabilities," said Seiberg in the analyst note. "The totality of these bills — and similar legislation and proposals — provides options on how to eventually break up the mega banks."

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