Updated from 4:16 p.m. EST

Securities regulators came down hard Monday on two banks that allowed favored clients to exploit the mutual funds they managed at the expense of small investors, leveling more than a half-billion dollars in penalties and disgorgements on Bank of America ( BAC) and FleetBoston ( FBF)

Bank of America got the worst of the action, although the distinction between it and FleetBoston has blurred since it agreed to acquire the New England banking giant in January. The nation's third-largest bank will fork over $250 million in restitution and $125 million in fines for allegedly allowing sophisticated investors to engage in the two arbitrage strategies at the center of the probe: market timing and late trading, according to the SEC and New York Attorney General Eliot Spitzer. Market timing is a frowned-upon strategy that involves rapid-fire trading in mutual fund shares in order to capitalize on price discrepancies in different markets. Late-trading is an illegal ploy that involves making sure-thing bets on mutual fund shares by buying them at prices set prior to the emergence of market-moving news.

In addition, eight directors of Nations Funds, Bank of America' s mutual fund arm, will leave the board over the next year for their role in approving a controversial measure that enabled a hedge fund to conduct company-sanctioned market timing of BOA funds, a release from Spitzer's office said. Bank of America will also exit the securities clearing business by the end of the year.

FleetBoston will pay $70 million in fines and $70 million in restitution for allowing market timing in funds managed and sold by its Columbia Management Advisors and Columbia Funds Distributor units. Money collected from both banks will go to mutual fund investors who lost money from the abuses.

"The fact that they settled with the merger closing soon isn't a big surprise," said Jeffrey Harte, a banking analyst at Sandler O'Neill. "But you didn't expect the dollar amount to be so large."

"In general, the fines that have been leveled have been pretty substantial. They're clearly sending a message from a regulatory perspective that the types of violations that have been alleged won't be tolerated," Harte said.

The two companies also agreed to reduce the fees they charge investors by $160 million over the next five years, bringing the total value of the settlement to $675 million and making it the biggest settlement yet in the mutual-fund trading scandal. Neither admitted guilt in the proceedings.

Bank of America said in September that it planned to make restitution to mutual fund shareholders who might have lost money through the improper trading. Former Bank of America broker Theodore Sihpol in September became the first securities industry employee to face criminal charges in the trading scandal on Sept. 16 when he was indicted on larceny and fraud charges. He later pleaded innocent.

Sihpol was charged two weeks after New York Attorney General Eliot Spitzer alleged that at least four mutual fund families had allowed illegal trading by a New Jersey hedge fund, Canary Capital Partners. The funds included ones offered by Bank of America's Nations Funds, Janus ( JNS), Bank One ( ONE) and Strong. Canary paid a $40 million fine.

In the settlement, regulators said Bank of America Capital Management "permitted the Canary hedge fund to engage in market timing in its Nations Funds," while Banc of America Securities "facilitated market timing and late trading by Canary and others by trading through broker Theodore C. Sihpol and by trading directly through BAS's clearing function through an electronic link." The reference is evidently to a special computer system the brokerage allegedly maintained to make mutual-fund arbitrage easier for some clients.

Both Bank of America and FleetBoston agreed to certain compliance and fund governance reforms that the SEC said will enhance the independence of its mutual fund governance oversight procedures.

Spitzer's office said total settlements agreed to in the mutual fund scandal now stand at $1.6 billion, a bigger take than was rung up in the 2002 probe into conflicted Wall Street research.