) -- You'll have to forgive the banking industry for not quite knowing how much capital it's supposed to have.

Before the fall of 2008, policies of the industry's three regulators -- the Federal Deposit Insurance Corp., the Federal Reserve and the Treasury -- were consistent in being collectively lenient and individually disparate. Now they're consistent only in being vague, even if the same rules remain on the books.

Though new standards won't be unveiled until the the Basel Committee on Banking Supervision comes to an agreement, a proposal by Sen. Susan Collins (R., Maine) would strengthen the implementation of those rules and thwart possible loopholes.

Oddly enough, Collins is meeting backlash not just from the industry but from two regulatory agencies. I'll get to how their ideas differ, why it matters and what may come of the reform, but first let me explain the Gordian knot of bank regulation and how the three entities are involved.

Sen. Susan Collins (left) has proposed strict new regulations on capital as part of the financial reform bill, and she's got the backing of FDIC Chairwoman Sheila Bair (right).

One might think that a bank is just a bank, but that isn't so. There are banks and thrifts, their holding companies and non-bank financial institutions that operate in the same markets as banks. The FDIC oversees banks, the Fed oversees bank holding companies, and the Treasury has oversight of everything thrift-related, though not for long.

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Under the proposed financial reform bill, the Fed will take over supervision of the holding companies, while the Treasury will shift responsibility for thrifts from the Office of Thrift Supervision -- which is being expunged -- to its other bank-regulatory agency, the Office of the Comptroller of the Currency. Non-bank firms -- like insurers that are regulated by state agencies, or others like hedge funds and private equity firms that are barely regulated at all -- will also belong to the Fed.

Got all that? Good.

The three agencies each set their own capital adequacy guidelines, though the Fed's are generally considered to be the rule of thumb: A 10% ratio of capital-to-risk-based assets; a 6% ratio of Tier 1 capital-to-risk-based-assets; and a 5% leverage ratio makes for a well-capitalized bank.

There are other ratios that deem a bank "adequately capitalized" -- or undercapitalized -- though they have largely been made irrelevant in the capital-sensitive environment that has emerged since the financial crisis took hold. In fact, even the "10, 6 and 5" standard, as one banking lawyer terms it, is almost laughably irrelevant: The Fed required higher levels and higher standards when administering stress tests last year; FDIC-insured institutions now have an average risk-weighted capital ratio of 12.09%.

"They introduced a new capital ratio," says Robert Klingler, an attorney who works with financial institutions at Bryan Cave. "In the stress test analysis, the regulators looked to the plain-vanilla common stock in relation to risk-weighted assets. At the time, the regulators stated that the new measure wasn't intended to be a new capital standard, but rather was just to reemphasize the importance of common stock."

Of course, investors had waited for the stress-test results with bated breath, and the market soared with a sigh of relief once the results were made public. Investors now place a premium on that type of core capital above all else.

"Separate from the capital standards, common equity is what the investment community wants and expects," says Klingler. "Investors seem to have disregarded everything other than common stock. But whether to invest in a bank is different from whether it's safe and sound. They go hand in hand, but it should be a different measurement."

Indeed, the regulatory community appears to be taking its cue from the investment community as well. The Fed's stress tests came after months of the market pummeling banks whose tangible common equity metrics were thought to be insufficient. As expectations have changed, though, the rules on the books haven't.

Those official standards for capital ratios are expected to come soon, when the Basel Committee's secretive deliberations come to an end. Central bankers and regulators from 27 countries have been negotiating for quite awhile now, and some fear the new standards will force banks to raise hundreds of billions of dollars' worth of capital and chip away further at the bottom line.

Because of that uncertainty, it's become difficult to trust regulators' transitory capital notions, or even understand what the policies are. For instance, Kevin Mukri, a spokesman for the Office of the Comptroller of the Currency,

recently acknowledged that the agency is analyzing banks' capital adequacy on something of an ad-hoc basis until official standards are set.

"The bank's condition may warrant higher capital but that depends on the condition of the individual bank," he said.

The Collins amendment doesn't call for any specific ratio, but would apply rules across the board -- to banks, thrifts, investment banks and any non-bank entity that is regulated by the U.S. government. It would also apply standards not just at the bank level, but at the holding-company level as well. That way, a diversified institution can't have strong capital metrics in its bank subsidiary while its proprietary trading arm runs amok.

There are other tough-sounding rules aimed at bigger banks engaged in riskier practices, but the most controversial item in the Collins amendment hasn't been any of those. Instead, it's a requirement that firms exclude a type of subordinated debt called

trust preferred securities, that smaller banks have relied upon heavily shore up Tier 1 capital levels. Under the Collins rule, banks would probably have to rely solely on common stock, as well as paid-in capital and retained earnings.

Therein lies the controversy.

Bryan Cave estimates the Collins rule could sap about $129 billion from the U.S. banking industry's collective balance sheet. The average bank would face a decline of 200 basis points in its capital ratio, and the industry may need to get rid of $1.3 trillion worth of assets to right-size balance sheets. The amendment would thereby contribute to

the lending dilemma that the government has been trying to fix, despite contradictory policies.

When asked whether banks will raise fresh funds or simply deleverage, Oliver Ireland, a partner at San Francisco-based law firm Morrison & Foerster who works with financial companies, said it's hard to tell.

"I would have one view of that before the Greek-European meltdown of the last few weeks and maybe another view now," says Ireland. "I think there's a real issue of cost of capital. You get into an economic difficulty and everybody decides the answer to this is to increase capital. Then you raise the capital requirements when it's hardest to raise capital."

Small banks may have a much harder time dealing with the change than firms with a big presence on Wall Street -- for just that reason.

"A $200 million community bank that's privately held can't go and say, 'I want to raise $1 million on Wall Street,'" explains Klingler. "There's just no interest. The elimination of trust preferred as Tier 1 capital would take capital away from the banks that needs it most."

Rochdale Securities analyst Richard Bove recently identified

Hudson City



TFS Financial

(TFSL) - Get Report


East West Bancorp

(EWBC) - Get Report


State Street

(STT) - Get Report


International Bancshares

(IBOC) - Get Report

as the top five banks in a list of those that stand to be "most in jeopardy" if the Collins amendment is passed in its current form.

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Of the 58 banks that comprise Bove's list, only six of them have more than $250 billion in assets -- the size of the banks that Collins says she is targeting -- and none of them appear in the top 30.

In recent quarters, stress in the TruPS market has also forced write-downs for smaller banks that hold them as assets. The securities have declined in issuance for at least three years, according to Bryan Cave's Klingler, as it became clear that distressed banks couldn't make good on promises to repay the debt. While there's been chatter of phasing in the Collins amendment over a period of a couple of years, the general timeframe for TruPS expiration is 20 years -- not nearly enough time to avoid the hearty amount of capital-raising and deleveraging that would need to occur.

The FDIC has long opposed using trust preferred securities as Tier 1 capital, saying that, as debt, the items belong on the other side of the capital equation. FDIC Chairwoman Sheila Bair is an avid supporter of the Collins proposal -- an odd position for her to take, since she's been a champion of community banks in most of her other policy positions.

Perhaps less surprisingly, Bair's position works against the recommendations of other regulators. Bair is often at loggerheads with her colleagues and hasn't been shy about publicizing those disagreements -- in op-eds, in testimony before Congress and in meetings with the president and his top advisers. But it appears that her motivation is less about politics or about supporting the little guy than it is about creating what she considers to be the right framework for keeping the U.S. banking industry alive and healthy.

For their part, the Fed and Treasury have been more circumspect about harsh changes to capital standards, given the industry's ongoing stress. In their view, the practical implications in the short-term are more important than whether TruPS are technically debt or equity, or whether they will endure beyond the foreseeable future.

Ireland of Morrison & Foerster notes that the three regulators have had inconsistent views on a lot of supervisory issues, and that in the issue of trust preferred securities as capital "what we're talking about here is the numerator of the capital calculations, not even the denominator."

For instance, he points out, regulators assigned the same risk-weight to residential mortgages - regardless of type. Subprime or Alt-A mortgages with 100% loan-to-value ratios and prime mortgages with a 20% down payment were all painted with the same 50% risk-weighted brush.

"There's a false precision in the capital rules to begin with," says Ireland, who went on to explain the variations and inconsistencies. "Those aren't the same risk, but they get the same risk weight."

The Treasury Department provides an even more puzzling example. The regulator had encouraged banks to buy preferred stock of

Fannie Mae

( FNM) and

Freddie Mac

( FRE)

"without limit" before the financial crisis. It assigned those securities a 20% risk weighting, vs. 100% from three other regulators.

But in September 2008, the Treasury placed Fannie and Freddie into conservatorship, thereby leaving gaping holes in dozens of bank balance sheets.

The FDIC doesn't have a clean slate when it comes to judging the safety of securities, either. The agency allows banks to invest up to 100% of their Tier 1 capital in auction-rate preferred stock, which was once believed to be a liquid, cash-like instrument. The ARS market froze up in the middle of 2008, and remains icy today. As a result, banks have been forced to write down those holdings.

Additionally, the ARS situation also led to billions of dollars' worth of settlements and fines for firms like

Bank of America

(BAC) - Get Report


Wells Fargo

(WFC) - Get Report



(C) - Get Report


JPMorgan Chase

(JPM) - Get Report


Morgan Stanley

(MS) - Get Report


Goldman Sachs

(GS) - Get Report


Deutsche Bank

(DB) - Get Report


Credit Suisse

(CS) - Get Report

. Those firms faced class-action lawsuits from investors and attorneys general who alleged that they had improperly marketed the securities as safe and liquid.

But, by that logic, so did the federal government.

Perhaps the most ironic part of the Collins proposal is that it could render preferred stock unusable for capital adequacy standards as well. The federal government issued just that type of security to rescue the banking industry through TARP.

When asked what incentives Collins might have had to sponsor the amendment -- given the public's lack of interest in or understanding of capital semantics -- Bryan Cave's Klingler responded thus: "Politically why you'd want to get behind this I don't know. It's part of a bigger philosophical question of, 'What is capital supposed to represent at the banks?'"

-- Written by Lauren Tara LaCapra in New York