A freshly minted accounting rule will simplify the largest banks' balance sheets by early next year.

Getting them through the clean-up process, however, will require some finesse from regulators.

Earlier this week, the Financial Accounting Standards Board, which sets U.S. accounting rules, ordered banks to consolidate their so-called off-balance-sheet entities by the first quarter of 2010. The transparency-minded moves will do away with a boom-time practice that helped financial firms increase their operating leverage.

The new rules will also undoubtedly chip away at the capital levels of Bank of America Corp. (BAC), Citigroup Inc. (C), JPMorgan Chase & Co. (JPM) and Wells Fargo & Co. (WFC). The government's recently completed stress test of banks reportedly factored in banks' off-balance-sheet exposures, but regulators may have to accommodate the new dictates by ratcheting up related capital requirements for banks slowly over time.

"The regulators do not want an accounting change to suddenly negatively affect the banks' capital ratios," said Bimal Shah, an analyst at Fox-Pitt Kelton. He said regulators are still deliberating the specifics of how to tell banks to apply the rules.

According to a report from Shah on Friday, Bank of America's tangible common equity ratio would fall in the first quarter of 2010 to 3.1%, as measured against tangible assets, from a projected 3.8% once the firm consolidates its off-balance-sheet exposure. Wells Fargo's would fall to 3.72% from 4.41%, and JPMorgan's would fall to 3.95% from 4.40%.

In normal times, firms typically have TCE ratios of 5% to 6% or more. Low TCE ratios can be a warning that a firm will have to raise capital, which can dilute existing shareholders.

Off-balance-sheet entities are something of a relic from the recent credit boom, when large banks wrote loans and sold them off to investors in soaring volumes, earning hefty fees in the process. Banks used a host of methods to turn loans over quickly, and creating off-balance-sheet entities was one of them.

Banks typically sold an array of loans to these arcane entities - which will become extinct under the new rules - and the entities typically issued commercial debt to fund the purchase. Banks could argue that they had sold off the loans and therefore didn't need to hold capital against them, as banks have to do with conventional loans in case they become delinquent.

As the credit crisis peaked, however, it became clear to investors and depositors that banks were in fact exposed to losses from loans they'd technically sold to off-balance-sheet entities. In many cases, for example, banks agreed to guarantee the performance of the sold loans, which means they'd be forced to repurchase bad loans if too much of the debt they had sold turned sour.

The fuzzy nature of these relationships, which banks thinly disclose through filings, makes it difficult for investors to assess how much off-balance-sheet risk each large bank is exposed to. The new accounting rule will likely make those exposures clearer to investors in the future.

"It certainly sounds like we'll have more transparency," said Anthony Polini, an analyst at Raymond James Financial Inc.

State Street Corp. (STT) was rocked early this year when it was forced to step in and support more than $20 billion in off-balance-sheet assets. The firm addressed the lingering issue Monday, when it raised capital and took the assets onto its balance sheet ahead of the Dec. 31 deadline.

-By Marshall Eckblad, Dow Jones Newswires; 201-938-4306; marshall.eckblad@dowjones.com