Global regulators will dilute a reform that forces banks to hold more reserves to survive shocks without massive taxpayer help again, sources familiar with the negotiations said on Friday.

The Group of 20 leading countries meet in Toronto on Saturday and Sunday to discuss how financial regulation can be toughened up after the sector's worst crisis since the 1930s.

G20 leaders want progress on a reform known as Basel III that requires banks to set aside far more capital and hold a minimum level of liquid assets from the end of 2012.

Banks have been lobbying hard to water down the draft rules, saying they would have to raise so much fresh capital that economic recovery and lending would be jeopardized.

The G20 meeting will discuss the latest version of Basel III drafted by the Basel Committee of global central bankers and supervisors that contains some concessions to banks.

We are in talks to make appropriate adjustment if there are what is seen as too much in the proposed regulation, a source familiar with the negotiations said.

The Basel Committee has basically agreed not to entirely exclude deferred tax assets, software and other intangible assets from core Tier 1, meaning they are likely to count some of them into the core capital in addition to common equity and retained earnings, the source said.

The original proposal had said retained earnings and common equity should form the vast majority of a bank's core capital.

The Financial Times reported on Friday that a provision to force banks to maintain a net stable funding ratio (NSFR), which aligns a minimum amount of stable funding with the liquidity characteristics of an institution's assets -- will be dropped and replaced with an alternative system of oversight.

PRESSURE TO PUBLISH

There is a battle behind the scenes at the G20 over whether the Basel Committee should give markets an earlier indication of the package's final version which is due in November.

Some policymakers feel this would give banks extra time to build up reserves and give investors more clarity.

Basel Committee Chairman, Nout Wellink, has already said there will be changes in substance and timing, though not of a fundamental nature. G20 finance ministers have said there will also be a longer phase-in.

The Bank of England said in its Financial Stability Report on Friday an extended transition to Basel III would enable banks to build resilience through greater retention of earnings, while sustaining lending.

In recent weeks, banks have been focusing on changing the NSFR plan, saying it was impossible to reconcile their short-term funding with 20 to 25 year loans.

Experts said the shift on NSFR gives national supervisors wiggle room to interpret the new rules more leniently.

Given that the NSFR is one of the rougher bits of the Basel III regime, that would be very welcome, said Simon Gleeson, a financial services lawyer at Clifford Chance,

Andew Lim, an analyst at Matrix said most banks fail when it comes to complying with the draft NSFR rule.

By most accounts, the sector is estimated to have a NSFR ratio of 85 percent on the whole, equating to a shortfall of about two trillion euros of funding against a minimum requirement of a 100 percent NSFR, Lim said.

There is already slippage in key banking reforms.

The Basel Committee has said the introduction of its rules to increase how much capital banks must hold on their trading books will be delayed a year until the end of 2011.

(Additional reporting by Noriyuki Hirata and Taiga Uranaka in Tokyo; editing by Mike Peacock)

G20