NEW YORK (Reuters) - Planned U.S. regulatory reforms may strain profits at the biggest banks during good times, but will likely boost profits during difficult times, which could ultimately help stock valuations in the sector, experts said.

Treasury Secretary Timothy Geithner disclosed elements of a plan on Thursday to change the way the U.S. regulates the financial sector. The plan calls for stronger oversight of many previously unregulated players.

But Geithner also said he would like extra scrutiny of banks and other institutions whose failure could rattle the entire financial system.

These "systemically important" institutions should have additional capital and risk management requirements and their own regulator, he said.

These steps could create two classes of financial companies: smaller firms that will face some regulation, and very large banks, insurers, hedge funds, and brokerages that will face much stricter rules.

Such a split could be as important as the division that the Glass-Steagall act made in 1933, when it separated banks' lending arms from their securities businesses to protect bank deposits from risky trading activity. But instead of splitting up individual firms into separate businesses, Geithner will regulate large firms and small firms separately.

"If you're a systemically important company, you are ultimately backed by taxpayers, not just shareholders, so it makes sense to look at regulation this way," said Karen Shaw Petrou, managing partner at research and consulting firm Federal Financial Analytics in Washington.

To many investors, increased regulation means decreased profitability. Stocks of the biggest banks dropped on Thursday, with Wells Fargo & Co, for example, down 2.9 percent.

But increased regulation could actually help some banks. Regulation adds a cost of doing business that could make it harder for newer entrants to build competing global banks.

"That might turn down competition," said Markus Brunnermeier, an economics professor at Princeton who has looked at systemic risk.

And the largest banks will still be best positioned to compete in global businesses like corporate bond underwriting, said Roy Smith, professor at New York University's Stern School of Business.

"The largest banks will still have a big advantage in many areas," Smith said.

DAMPENING THE CYCLE

During the most recent boom, large U.S. commercial banks turned in returns on common equity, a measure of profitability, of around 20 percent. For investment banks, that figure was closer to 25 or 30 percent.

Returns on equity for large financial companies may be closer to the high teens in coming years, said Federal Financial Analytics' Petrou. That may not look great compared to earlier this decade, but it's much better than the negative returns on equity that many major U.S. financial institutions posted in the fourth quarter.

"Your booms will be dampened, but so will your busts," said Dan Alpert, managing director at boutique investment bank Westwood Capital in New York.

More stable earnings streams often translate to higher valuations and could help attract workers looking for high compensation with less risk, analysts noted.

"The big banks will still earn substantial income, and they'll do it fairly steadily. Plenty of people would be happy to work at that kind of an institution," NYU's Smith said.

(Editing by Phil Berlowitz)