When the dust settles on this financial crisis, regulators may force investment banks to hold almost as much capital as commercial banks.

That could be tough for Wall Street to swallow, because it could translate to lower profits and lower stock prices.

But as long as investment banks are entitled to borrow money from the Federal Reserve, they will likely have to play by the government’s rules, analysts said.

“The taxpayer has a right to a voice in what he’s going to be insuring in the future,” said Roy Smith, a professor at New York University’s Stern School of Business and a former partner at Goldman Sachs.

One area that regulators might focus on, analysts said, is an investment bank’s total assets—including stocks, bonds and mortgages—relative to shareholder equity, or the ownership interest of shareholders.

Regulators have so far evaluated the adequacy of an investment bank’s capital mainly by focusing on the riskiness of its assets, which essentially has translated to allowing banks to hold less capital for lower-risk assets.

There is some validity to that approach. Dealers have large inventories of low-risk securities such as Treasuries, which inflate their balance sheets but do not necessarily need to be offset by much capital.

But during this crisis, some securities that seemed low risk have suddenly proved difficult to finance, pushing their owners to the brink of bankruptcy.

Just ask Carlyle Capital Corp, an Amsterdam-listed fund that invested in mortgage-backed securities with top ratings. The fund—an offshoot of one of the world’s largest private equity firms—lost access to financing in March and was declared insolvent.

Or investment bank Bear Stearns Cos Inc, which suffered a run on the bank in mid-March and lost its ability to finance many of its as-sets, forcing it to sell itself to JPMorgan Chase & Co at a bargain price.

That’s why investment bank regulators are likely to look at ratios of tangible equity to tangible assets, such as the tier one leverage ratio, said Adam Compton, co-head of global financial stock research at RCM in San Francisco, which manages more than $150 billion of assets.

These ratios signal how much of a company’s assets are financed by equity, stripping out intangible assets like goodwill, which could easily be written down in a downturn.

If that ratio is too low, an investment bank may be taking on too many assets, Compton said. “It’s not a perfect measure of risk. None are perfect. But it can tell you if their balance sheets are getting too big,” Compton said.

From 30, Closer To 10

Commercial banks typically have about 10 times as much assets as equity. For investment banks, it’s a different story: Lehman Brothers Holdings Inc, for example, had about 31.7 times as much assets as equity at the end of February, up from 26.2 times at the end of November 2006. Morgan Stanley had 32.6 times as much.

“We’ll probably see investment banks’ capital levels move closer to commercial banks. I don’t know where exactly they’ll end up, and until housing and credit markets stabilize, we won’t know,” said Jim Huguet, co-chief executive at asset manager Great Companies LLC.

For now, the year-long credit crunch has forced investment banks to hold more capital even without a push from regulators. Companies not perceived as well capitalized are facing much higher borrowing costs and lower share prices. A higher cost of borrowing eats into a investment bank’s bottom line, giving it a real incentive to boost its capital levels.

But if investment banks continue to rely on access to the Federal Reserve’s discount window to support their businesses, higher capital levels may become mandatory rather than optional, analysts said.

Higher capital levels may force investment banks out of certain kinds of business with narrow profit margins, said Robert Litan, a senior fellow in the economic studies program at the Brookings Institution in Washington, D.C.

For example, fixed-income arbitrage—which often entails taking positions on the relative valuation of different kinds of bonds and derivatives—may only be profitable if the investment bank is exposed in a massive way.

Reuters