A fight over an Obama administration proposal to create a new U.S. watchdog for consumer financial products threatened on Friday to derail progress toward tighter bank and capital market regulation, amid much posturing on both sides.

Democrats want an independent agency that can clamp down on abusive mortgages and credit cards, but Republicans and bank lobbyists want a tamer beast that won't threaten profits too much and that answers to a higher master.

The White House proposal to create a U.S. Consumer Financial Protection Agency (CFPA) has emerged as the main impediment to bipartisan agreement on financial regulation reform, one of the White House's major priorities for 2010.

With the Senate Banking Committee targeting a legislative drafting session as soon as early March, the next two weeks will be crucial in deciding whether the United States keeps pace with the European Union on a global push for reform.

The White House must compromise on the issue, Senator Bob Corker, the Republicans' chief negotiator on the issue, told Reuters. If not, there may not be a bill, said the first-term lawmaker from Tennessee.

White House spokesman Robert Gibbs said President Barack Obama still sees a consumer protection agency as a top goal.

In terms of the consumer office, the president still believes it's a great priority to have the independent authority to ensure that consumers in this reform are protected, he said. We need to have independent authority ... that's what consumers want for their protection.

Bank lobbyists have worked for months to kill or weaken the CFPA, which threatens bank profits, while Republicans have attacked it as an excessive intrusion into business that would unwisely divorce bank supervision from consumer protection.

Democrats generally support the White House proposal, saying it would shield Americans from abusive financial products, also including payday loans and pawn shops, and that this job was handled poorly by existing U.S. regulators in the run-up to the recent worldwide financial crisis.

Republican Senator Judd Gregg said lawmakers from both parties share common ground on financial regulation, but the White House's stance on consumer protection is an obstacle.

The only really big philosophical difference here is how you protect consumers, Gregg said in a CNBC TV interview.

SENATE REFORM PASSAGE SEEN IN SUMMER

Some form of financial reform will likely pass the Senate over the summer, said Paul Miller, a policy analyst at investment advisory group FBR Capital Markets Corp.

The CFPA will probably end up as part of another regulatory agency, with some rulemaking authority, but only minimal enforcement power, Miller said.

As such, we believe the CFPA will be a thorn in banks' sides, but it will not be crippling by any means and should not affect current valuations, he said.

Corker said he supports creating a new head of financial consumer protection who would be confirmed by the Senate, while also giving a new watchdog entity some rule-making power.

But he said the watchdog should be embedded within a larger regulatory authority able to check that rule-making power.

Suggesting room for bipartisan compromise, Senator Jack Reed, a top banking committee Democrat, said, I think, frankly, we do need an independent CFPA. ... Now you could situate it within a department if it's autonomous enough.

Obama's original proposal, adopted by the U.S. House of Representatives in December in a sweeping financial reforms bill, was for an independent agency that would centralize the consumer protection laws and staffs of several existing bank regulators, including the Federal Reserve.

TARULLO BACKS COUNCIL

The debate over the CFPA sharpened as Federal Reserve Governor Daniel Tarullo told a Senate subcommittee that he favors allowing a council of existing regulators to collect and analyze data on systemic risks in the financial system, rather than creating a new agency to do so.

Separately, Democratic Senator Jeff Merkley said on Friday that he is writing a bill that would widen the White House's House proposal to limit risky investing, extending the reach to nonbank financial institutions as well as to banks.

In a letter to colleagues, Merkley said his bill would apply to nonbank financial institutions large enough to be systemically critical. Firms would be prohibited from owning or operating hedge funds and private equity funds and from engaging in proprietary trading, or using their own capital to pursue above-market returns unrelated to customer needs.

(Additional reporting by Steve Holland, Matt Spetalnick, Corbett Daly, David Morgan and David Lawder; Editing by Leslie Adler)

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