The nation's financial regulatory system needs fixing, and bankers can be certain changes are coming. But after months of Congressional hearings, debates and some hysterics, that's still about all the industry knows for sure. Only the broadest outlines of the new regulatory regime have emerged, and Capitol Hill watchers say the window for sweeping changes to occur quickly — and some worried in anger — has probably closed. Instead, regulatory reform is shaping up to be a slow grind through Congress that may last a year or more. Some say the real deadline for passage is not until the summer of 2010, when mid-term campaigning kicks off in earnest.

On balance, this is probably a positive development. Bankers, especially community bankers, fret that a rush to enact reforms — particularly in an industry as complicated, fractured and heavily regulated as financial services — could unfairly target banks that bear little responsibility for the financial crisis. In fact, there is even cautious optimism among some community bankers that the reforms under discussion — from those that would raise the capital levels of too-big-to-fail institutions, to the push for national, uniform standards on regulating particular financial instruments such as mortgages — might actually give outgunned smaller banks a better shot in certain markets and products.

Brian Gardner, a vice president at Keefe, Bruyette & Woods, says, "We could end up with a bifurcated system, with a core banking system [made up of the too-big-to fail banks] that has more regulations and capital requirements. For smaller banks, that could be beneficial."

Historically, community banks have held more capital than big banks, and larger banks have used their funding advantages and their scale to offer better pricing on loans. Requiring larger banks to hold more capital could change the math on a range of products, bankers say, particularly business-related loans and mortgages, giving community banks a chance to compete for business they have been ceding to big institutions. "The new capital rules will change a lot of business plans," says Tom Hoy, CEO of the $1.7 billion-asset Arrow Financial Corp., a two-bank holding company in Glens Falls, N.Y. "I think community banks will be very competitive coming out of this. I'm very optimistic."

Smaller banks have been losing market share in virtually every loan category for years, as the biggest banks and nonbank financial institutions consolidated their power and reached deeper into consumer and small-business lending. From 1998 to 2008, commercial banks with $10 billion of assets or more increased their market share of 1-to-4 family home mortgages from 56.3 percent to 79.7 percent, home equity loans from 66.7 percent to 88.1 percent, and individual loans — including credit cards — from 57.6 percent to 88.6 percent, according to Federal Deposit Insurance Corp figures. Smaller banks even lost ground in their strongest loan categories. From 1998 to 2008, banks with $100 million to $10 billion of assets saw their hold on the commercial-loan market fall by 18 percent.

There are no guarantees, of course, that these trends will be markedly reversed under a new regulatory structure, but the prospect of stepped-up capital requirements for large banks is a welcome change for their smaller competitors.

Just a year ago the international community was poised to lower capital ratios for big banks through the Basel II accord; smaller banks protested bitterly that lowering capital requirements for large institutions would crimp their competitiveness even more. That prospect appears to have faded, though Bert Ely, an industry consultant in Alexandria, Va., warns against community banks taking anything for granted so soon in the regulatory reform process. "I understand the argument" that higher capital requirement for big banks could help smaller banks compete, Ely says. "But it's all incredibly fuzzy right now. It's difficult to discuss these [regulatory] proposals at this time because we just don't know the specifics."

And make no mistake, there are many specifics to fill in. Much of what the industry knows for sure about the direction reform is taking comes from Treasury Secretary Tim Geithner's appearance before the House Financial Services Committee in late March; there he outlined the administration's priorities and goals for reform. As expected, he used broad strokes, yet he did frame two linchpin ideas that seem almost certain to wind up in a final bill. One is the creation of a systemic risk overseer of financial institutions considered too big to fail, armed with a mechanism to unwind these institutions; the other is creating a wider regulatory net to capture previously unregulated corners of the "shadow" banking system, such as credit default swaps and hedge funds.

Until recently, quick action on these reforms seemed possible. President Obama hit the ground running in January fueled by ample political capital and the determination to get results on a number of fronts in the first 100 days of his administration. The public was angry about the hundreds of billions being funneled into banks and the administration seemed determined to fix the system, quickly. But while Congress has held a host of hearings, there is little agreement — particularly between House Financial Services Committee chairman Barney Frank (D-Mass.), and Senate Banking Committee chairman Christopher Dodd (D-Conn.) — on what a new regulatory structure should look like.

"There's been a lot of talk, but I doubt things are going to move as fast as many people think," says Ely. "I've been around this town a long time, and there are so many cross-currents. I'm dubious how quickly or dramatically reform will happen. The existing structure, the status quo, has many powerful supporters."

A go-slower approach is a welcome relief for many who support reforms but worry that the entire industry is being painted with the same broad "bailout" brush. "The general public, and I'm afraid Congress, are lumping the banking industry in with all financial institutions into a homogenous pool, and it's not that way," says Arrow Financial's Hoy. "We've been heavily regulated right along, and many of us have not had significant problems."

How the government addresses the systemic risk is a major concern among all bankers; generally speaking, they say the top financial institutions need reining in for the sake of the larger economy, and that new regulations could remedy some unfair leverage and funding advantages the big banks currently enjoy. If different rules apply to the too-big-to-fail banks when they teeter — in the form of government support — they should follow a different set of rules during the good times. Otherwise the risk/reward tradeoff is skewed and healthy competition is difficult. "I don't see why it's so confusing to folks. If you're going to have two sets of rules in the reactive mode, then you need two sets of rules in the proactive mode. It's that simple, and maybe you encourage some banks not to get so big," says Charlie Brown, the CEO at the $117 million-asset Insignia Bank in Sarasota, Fla.

To control systemic risk, Geithner says that the government should create an independent agency to monitor the risk positions of major institutions or payment systems whose failure could destabilize the economy. He also has proposed that mammoth conglomerate institutions set aside a greater portion of their capital to protect against failure. Additionally, the Treasury secretary pushed for government authority to seize and unwind large nonbank financial institutions that pose systemic risk in the same way the FDIC can now seize banks. Left unsaid was the means to accomplish that: questions abound about what agency would be the systemic risk regulator; what defines "too big to fail"; what those capital levels would be; how they would be determined; and what agency would be responsible for seizing nonbank institutions.

Even former Federal Reserve Chairman Alan Greenspan, hardly a market interventionist, said during a recent speech at the Brookings Institution that institutions with such systemic risk capacity must be regulated differently. Echoing Geithner, Greenspan said regulators could set capital requirement higher for these banks to offset their lower borrowing costs, which they enjoy based on the expectation that creditors will be backed by the government.

According to FDIC data, commercial banks with $10 billion of assets or more had an average Tier 1 capital ratio of 9.15 percent at Dec. 31, while banks with less than $100 million of assets, on average, had a Tier 1 ratio of 17.44 percent. Banks in the $100 million- to $1 billion-asset class had Tier 1 ratio, on average, of 12.28 percent.

"Big banks have had a huge advantage by not being required to hold the same capital levels because, of course, capital has a cost," says John Puffer, CEO at the $253 million-asset Pilot Bank, in Tampa. "Requiring big banks to incur those costs would have a tendency to level the playing field."

Puffer says he believes his bank could better compete for commercial and industrial loans if capital requirements are changed.

How exactly regulators would set new capital levels is still one of the many unknowns. Would banks of a certain size — still to be determined — simply be required to hold more capital based just on their size? Or will there be a risk-based approach, where institutions in riskier lines of business hold greater amounts of capital? Will regulators rely on some combination of the two approaches? "If larger banks are getting into more aggressive and riskier lines of business, they should hold more capital," argues Brown. Besides a company's risk profile and size, complexity should also influence capital levels, he says. As the market has learned, complexity, even when intended to remove risk, is difficult to model and can create huge losses.

Many executives at large banks are keeping a low profile these days and have been mum about possible new capital requirements. But Scott Talbot, senior vice president of government affairs at the Financial Services Roundtable, points out that big banks generally support Basel II's risk-based capital model, so it stands to reason they would favor a similar model under a new regulatory structure.

Still, Talbot takes issue with community bankers and their representatives who are itching to jack up capital requirements on big banks. "Some of the small guys want high capital ratios not for safety and soundness reasons, but because it's more expensive for the big banks. To me that's the wrong motivation. They're taking a competitive angle as opposed to what's best for the economy."

Of course, regulators today are concerned with plugging regulatory gaps, not giving small banks a handicap. But Hoy argues greater fairness and healthier competition may result. "When competition is weighted by the risk you take," competition is more robust, which means the market itself is healthier. A perfect example is residential mortgages, he says. Mortgage securitization consumed huge volumes of mortgages and didn't require big banks and nonbank originators to hold them on their books; that allowed them to steamroll community banks. Changing the equation means that community banks can better compete for local mortgages, Hoy says.

While the debate around larger institutions centers on controlling the risks they pose, some also question whether the interdependent hazards in a "too big to fail" model can ever be tamed. "We should be trying to eliminate systemic risk, instead of creating elaborate structures to try and regulate it," says Paul Merski, chief economist at the Independent Community Bankers Association. "Some of these institutions may be too big to fail and too big to regulate."

Proposed regulations of the so-called shadow banking system may also help smaller banks. At the same Congressional hearing in which Geithner outlined his vision for a systemic regulator, he also proposed new regulations for areas of the financial markets that have so far been lightly regulated, or unregulated. Hedge funds, private equity firms and venture capital outfits over a certain size should register with the Securities and Exchange Commission; meanwhile, oversight of derivatives, such as credit default swaps, should increase and a central clearinghouse for trades should be created.

Over time, these nonbank financial players have competed more directly — through mortgage originators and complex securitization products — with Main Street banks for local business. Investment banks, operating at much higher leverage ratios than commercial banks, have steadily moved down the lending chain in business, residential, student and auto loans, "constantly compressing the typical Main Street market," says Curt Hage, CEO of Home Federal Bank in Sioux City, S.D. But even without the new regulations in place, this is changing. The big Wall Street firms have ceased to exist or changed their charters, and in the absence of these active and highly leveraged institutions, Hage and other community bankers says Main Street banks are already winning back some commercial customers.

Some argue that regulatory gaps exploited by these nonbank players and highly leveraged national banks proves that rules should be uniform based on products being sold. Often these firms set up shop in states where regulations were least onerous, so it's no coincidence, that 94 percent of subprime mortgages came from nonbanks, and just six percent from traditional banks, says Edward Kramer, executive vice president of regulatory programs at Wolters Kluwer Financial Services.

Hage says lax regulations outside of traditional banking both encouraged the issuance of these risky mortgages and priced traditional banks out of the market. "If we had the same regulatory requirements for the same kinds of instruments, that would be a start," he says.

An opportunity to rewrite the rules of finance doesn't come along very often and lawmakers and regulators need to synthesize the lessons from the current crisis and get the new reforms right. Thoughtful reform is critical to prevent a repeat of the latest meltdown, and to position the U.S. financial markets to compete effectively in a global economy that did not exist 15 years ago, much less during the 1930s when the last wave of regulatory reform occurred.

"It needs to be a deliberative process. We need to reengineer regulations, not simply add another layer," adds Bob Jones, the chief executive at the $549 million-asset United Bank in Atmore, Ala. "My concern is we inflict more damage trying to fix the problem. We don't need to come out of this down cycle creating the next down cycle."

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