A controversial provision of the financial reform bill could further tighten the bind on banks still participating in the government bailout program.

Bank securities held by the Treasury Department through the Troubled Asset Relief Program would no longer count toward a banking company's Tier 1 capital under the Senate's version of the reform bill, legal experts said. That boost to Tier 1 capital was a key reason some banks chose to participate and why many remain. For many of them, keeping that capital support could be the reason they survive the prolonged economic malaise.

If unaltered, the provision — sponsored by Sen. Susan Collins, R-Maine — would force tough choices for a handful of big regional banks and hundreds of small banks. To restore Tier 1 ratios, banks may have to flood already stingy capital markets or pursue preferred-to-common stock conversions to the detriment of shareholders.

"It will immediately result in undercapitalization for a number of banks," said D. Barry Hester, a lawyer in the Atlanta office of Bryan Cave. "It would be like flipping the switch, where banks that are currently OK would suddenly need to raise more capital. It could be a disaster if it isn't phased in to let people plan ahead."

Michael Iannaccone, the president of MDI Investments Inc., said that nullifying trust-preferred and Tarp securities from Tier 1 could cause at least 350 banking companies to raise more capital. He noted that several regionals, such as Fifth Third Bancorp, Regions Financial Corp. and SunTrust Banks Inc., are still in Tarp.

"The banks I talk to are apoplectic … but they're resigned that it will go through," Iannaccone said. "It would be particularly devastating for the community banking industry."

A number of bankers have justified holding on to Tarp securities, with a 5% quarterly dividend over the first five years, because it represents a relatively cheap form of capital. That may no longer be the case if those securities are not allowed to raise Tier 1 ratios,.

The provision — aimed at trust-preferreds and other securities that are believed to include Tarp securities — was originally designed to tighten capital requirements for the biggest banks, observers said. "The undertone with the Senate floor vote was about sticking it to big banks," Hester said. "But the distinction wasn't made in the amendment itself."

One of the amendment's biggest backers is Sheila Bair, the chairman of the Federal Deposit Insurance Corp., who has been advocating for the measure as a way of tightening capital requirements for big banks. "This amendment is a critical element to ensure that U.S. financial institutions hold sufficient capital to absorb losses during future periods of financial stress," she wrote in a letter to Sen. Collins published by Barclays Capital in a May note.

"With new resolution authority, taxpayers will no longer bail out large financial institutions," Bair wrote. "This makes it imperative that they have sufficient capital to stand on their own in times of adversity."

But executives at smaller institutions said the amendment would be more disruptive to small banks. Most of the nation's biggest banks have already exited Tarp, selling significant amounts of common stock to do so. Meanwhile, more than 700 banks remain on the hook for Tarp funds of $1 billion or less per institution, most of them smaller institutions with limited opportunities to replace the shares.

Independent Bank Corp. in Ionia, Mich., is among the small banks left wondering what it might have to do to address the $72 million in Tarp assistance it received in December 2008, not to mention another $92 million in trust-preferred securities it holds.

Michael Magee, Independent's president and chief executive, said the $2.9 billion-asset company is "watching the issue extremely closely, but we remain in a wait-and-see mode." He said one option would be to convert some of the Tarp shares to common stock while also issuing new stock, though that would be "extremely dilutive" to shareholders. Still, Magee has hope that the Treasury, which he says is working with Independent, will find a way to ease the pain for small banks.

"I think people will work together to avoid a disaster here," Magee said.

There is some optimism that lawmakers will dilute the wording of the amendment as they reconcile the Senate and House versions of reform legislation. Those watching the process said they hope legislators either make an exception to let Tarp shares count toward Tier 1 capital or phase in implementation to avoid having a single rush to capital markets.

"I think at worst they'll grandfather existing securities," said Frank Barkocy, the director of research at Mendon Capital Advisors Corp.

Collins said this week that she was open to some alternatives such as phasing in her requirement.