The fate of investment banking at regional institutions may hinge on how their bigger competitors react to financial reform.

Though the reform bill wending its way through Congress will have little direct impact on regional banks' capital markets business, it could spur more competition from larger rivals.

Observers expect the giants to chase harder after middle-market lending and other businesses usually left for the midsize investment banks.

"The big guys could migrate down and compete against regional shops," said Paul Alapat, a managing director at Amba Research, a New York firm that serves investment banks and asset managers.

"They will try all avenues," Alapat said. "At the end of the day, smaller firms will have to watch out for themselves."

Regional banks are at least insulated from many of the biggest threats in the reform bill, analysts said. Few if any do the type of proprietary trading that would be restricted by the so-called Volcker Rule, and most will not be affected by provisions focused on how derivatives are cleared.

"Our overall reaction is that we've always done trading the old-fashioned way — as agents for our clients and not as principals," said Chip Grayson, head of corporate finance at Regions Financial Corp.'s Morgan Keegan & Co. Inc. "That's what the rules would force the bigger guys to do."

Rufus Yates, the president and chief executive of BB&T Corp.'s Scott & Stringfellow, concedes that the sweeping legislation and the crisis that precipitated it are a concern.

"Trust in the regionals remains very strong," he said, "but the environment we're in has created uncertainty in the eyes of clients on whether we can deliver the products and services." He said that, while it's possible larger rivals will vie for middle-market business, he views it as a near-term threat only.

"We believe any migration down into that segment would be temporary, because they're not set up to have a long-term focus there," Yates said.

Versions of the reform bill have been approved by both the House and the Senate; differences are being worked out now by a committee of lawmakers from both chambers.

Yates said the only aspect in either bill that really worries him is how lawmakers will reconcile the fiduciary trust of advisors, particularly if the final bill deems it a conflict for an investment bank to act as both an underwriter and market maker for the same client's securities.

Still, there is a belief that big banks, if hamstrung by proprietary-trading bans and other constraints may use their heft to challenge for smaller accounts. Such competition could be problematic for regional investment banks.

"It is already a very competitive business with margins that have been under pressure," said Jeff Davis, a managing director at Guggenheim Securities LLC. "Many regionals view those operations as modestly profitable," he said. "They are needed to support corporate lending."

The gulf between big and small is huge.

The four biggest banks held more than $153 billion in capital within their brokerage units at the end of 2009, according to SNL Financial.

Units at Morgan Stanley and Goldman Sachs Group Inc. collectively had more than $205 billion in capital at yearend.

In comparison, the brokerage units for the eight biggest regional shops held roughly $6 billion in total capital.

The biggest banks grew at a faster rate last year as well, with combined capital increasing 11.2%, compared with 8.2% at the regionals. (See chart above.)

But with size comes cost, Grayson noted.

"There will always be companies of a size that need sophistication but are too small for big firms such as Goldman or JPMorgan Chase," he said. "They have a huge cost structure and a machine to feed, and their business model breaks down if they try to serve the same companies that we serve."

Several regional shops are taking the offensive.

Morgan Keegan has acquired boutique firms such as Shattuck Hammond Partners LLC to expand in health care, Burke Capital Group LLC to target financial companies and Revolution Partners LLC to focus on technology.

Morgan Keegan has also been hiring senior bankers and now has 35 investment banking offices in far-flung markets as San Francisco, Chicago and Boston.

The unit also created a single investment banking division in March, naming longtime executive Robert Baird to oversee both fixed-income and equities operations.

BB&T is also eager to expand its corporate market, hiring bankers to focus on areas such as information technology, government services and health care. "We think there are opportunities to grow those relationships," Yates said.

Even companies not known for investment banking are on the move.

U.S. Bancorp lured a team of former Wachovia Securities bankers to open a Charlotte office earlier this year, and last month the Minneapolis company started a municipal bond underwriting business. Capital One Financial Corp. has been expanding research coverage at Capital One Southcoast, a unit it inherited with its 2005 purchase of Hibernia Corp.

Davis said it is unclear whether such steps will help regional firms maintain momentum and whether others will be willing to invest the capital needed to keep their firms competitive, particularly those that still must repay Troubled Asset Relief Program funds.

"So much of the banking industry is struggling to get back to a level of profitability," he said.

"I doubt many are going to channel capital into investment banking."