Banks would face tougher curbs on trading but would be able to hold limited hedge fund positions under a proposal unveiled by Senate Democrats as they closed in on a final overhaul of financial regulations.

The proposal, known as the Volcker rule, balances Democrats' desire to crack down on Wall Street with their need to retain the votes of moderates from both parties to pass the most sweeping overhaul of the Wall Street rulebook since the 1930s.

We think this proposal addresses the underlying concern of putting depository funds at risk, said Democrat Christopher Dodd, the top Senate negotiator. It puts a stop to proprietary trading but also recognizes that there are legitimate hedging activities that banks need to engage in.

Lawmakers from the House of Representatives on a panel tasked with hammering out a final bill had yet to weigh in on the proposal.

But they face enormous pressure to resolve the issue in the coming hours, before President Barack Obama discusses recovery and reform with other the leaders of other economic powers at the Group of 20 meeting in Canada.

Passage would also give Democrats an important legislative victory, alongside healthcare reform, ahead of congressional elections in November.

As the global economy emerges from the financial crisis of 2007-2009, Europe's efforts to present a united front on regulation hit a roadblock on Thursday when lawmakers and diplomats failed to agree on new hedge fund rules.

DUEL OVER DERIVATIVES

In Washington, lawmakers on the Senate-House panel had yet to address the contentious issue of derivatives regulation.

Dozens of House Democrats want to strip out a provision that would require banks to spin off their derivatives-trading operation but that measure's sponsor, Democratic Senator Blanche Lincoln, was holding firm.

Treasury Secretary Timothy Geithner worked with lawmakers to work through the standoff.

On Wall Street, the prospect of tough new rules sent U.S. bank stocks lower, helping to pull down the overall market. The KBW banks index closed down 2.2 percent.

The rewrite of the regulations -- nearly 2,000 pages in all -- aims to avoid a repeat of the crisis that plunged the global economy into a deep recession and led to taxpayer bailouts of troubled banks. It would saddle the industry with tougher oversight and could cut revenues by billions of dollars.

The House-Senate panel agreed to tighten bank capital rules to help them ride out future crises.

Banks would have five years to meet the rules, which force them to exclude some riskier securities from core capital. Banks with less than $15 billion in assets would be exempt.

Some $118 billion in bank assets would not count toward the new capital requirements, according to credit ratings agency Moody's Investors Service.

That could further worsen a credit crunch that is hampering economic recovery, said Jeff Davis, bank analyst at Guggenheim Partners, because banks may shrink their asset base to raise their capital levels.

Raising capital requirements right now is not helping the lending environment, Davis said.

LAW BY EARLY JULY?

Lawmakers resolved some of their sticking points on Thursday, agreeing to let regulators set higher standards of duty for broker-dealers who give financial advice.

They also watered down a provision to give shareholders a nonbinding vote on executive pay. That vote would take place once every two or three years, not annually.

Democrats hope Obama can sign the reforms into law by July 4 but the final package must first win approval in both chambers of Congress, where the votes of both liberal House Democrats and moderate Senate Republicans will be needed.

There are two very strong criticisms of this bill: one that it is too big and the other that it is too little, said Democratic Representative Barney Frank, the panel's chairman, who looked as rumpled as the staffers who had worked through Wednesday night.

Wall Street lobbyists have been unable to kill the overhaul as Democrats ride a wave of public disgust at bank bailouts and bonuses. Some 73 percent of Americans support strong financial reforms, according to a Lake Research Partners poll touted by Democrats on Thursday.

Still, members of the committee are likely to soften their toughest measures.

Dodd's proposal would toughen the trading ban on banks first suggested by White House economic adviser Paul Volcker by giving regulators less discretion to waive it.

But banks would be able to invest up to 3 percent of their tangible common equity in hedge funds and private equity funds, and bank investment in any single fund could not exceed 3 percent of the fund's capital.

The crackdown would force much trading activity onto exchanges and clearinghouses in a bid to tame a $615 trillion market that exacerbated the financial crisis and led to a $182 billion taxpayer bailout of insurance giant AIG.

Lincoln's provision would force banks to spin off swaps-dealing operations into separately capitalized units.

At least 81 House Democrats have objected to that measure and could vote against the final bill if the plan is included. One plan being circulated in the afternoon would require banks to spin off only their dealing in highly structured swaps but it was unclear whether it had any traction.

One Senate centrist, Republican Scott Brown, was at the center of efforts to weaken the Volcker rule, according to aides. Brown was poised to win exemptions sought by mutual funds, insurers and banks in his home state of Massachusetts.

(Additional reporting by Kim Dixon, Roberta Rampton, Rachelle Younglai, David Lawder and Charles Abbott in Washington and Leah Schnurr and Elinor Comlay in New York; writing by Andy Sullivan; Editing by Alistair Bell and John O'Callaghan)

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