Lawmakers on Thursday agreed to boost banks' capital requirements and neared agreement on a derivatives crackdown as they closed in on a historic overhaul of financial regulations.

Despite early progress in what lawmakers hope will be their final negotiating session, they had yet to tackle controversial proposals that would ban banks' proprietary trading activities and force them to spin off lucrative swaps-dealing operations.

Democrats in charge of the process look likely to retain tough restrictions on trading and investment activities by banks that could lower revenues by billions of dollars.

But with a self-imposed deadline of Thursday evening, last-minute deal making could lead to exemptions for mutual funds, manufacturers and other business interests.

The broadest rewrite of Wall Street rules since the 1930s aims to avoid a repeat of the 2007-2009 financial crisis that plunged the global economy into a deep recession and led to taxpayer bailouts of troubled banks.

Success would allow President Barack Obama to hold up the legislation as a model for other economic powers weighing reforms at this weekend's meeting of the Group of 20 nations in Canada.

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.

In the United States, congressional negotiators finalized a provision that would require banks to raise additional capital to help them ride out crises.

The prospect of tough new rules sent U.S. banks lower on Thursday, with the KBW bank index down more than 1.6 percent in early afternoon. On the Dow, JPMorgan Chase & Co was among the biggest weights, off 2.7 percent at $37.84. Bank of America shed 2.1 percent to $15.11.

Clearly the regulation coming out of Washington is a concern and as we get closer and closer there are more and more rumors and the stocks are reacting, said David Katz, chief investment officer at Matrix Asset Advisors in New York.

FAILURE NOT AN OPTION

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

Failure is not an option, said Democratic Senator Christopher Dodd, the Senate's lead negotiator.

The notion somehow that we would leave here and by a vote or two fail to do this and leave the country as vulnerable today as it was ... when we came to the brink of disaster, he said, would be the height of irresponsibility.

In the first hour of a session that could last late into the night, negotiators made some progress as they tried to resolve separate bills passed by the House of Representatives and the Senate.

Wall Street lobbyists have been unable to kill the overhaul as Democrats ride a wave of public disgust at bank bailouts and bonuses.

Still, members of the committee are likely to soften their toughest proposals to retain the support of centrist lawmakers whose votes will be needed for the merged bill to clear both chambers of Congress before it is sent to Obama.

Dodd said he was prepared to accept the overwhelming majority of tweaks suggested by his House counterparts to the derivatives crackdown, though he did not say which ones.

House lawmakers have proposed 110 changes to the law that could benefit a wide range of players, from manufacturers like Caterpillar to dominant futures-exchange operator CME Group.

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.

SWAPS SPIN-OFF UNRESOLVED

Still unresolved was a controversial provision backed by Democratic Senator Blanche Lincoln to 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 it includes Lincoln's provision. Their concerns remain unresolved, a House aide said.

Gary Gensler, the regulator who convinced lawmakers to give his Commodity Futures Trading Commission vast new power over the derivatives market, took a front-row seat as the panel deliberated. Gensler has remained publicly neutral on Lincoln's provision, but has pushed to limit exemptions for end users ranging from airlines to agribusiness.

Under the deal reached on bank capital, banks would have five years to meet the new higher requirements, and those 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 Moody's.

Like Lincoln's proposal, that measure is championed by another Senate centrist whose vote will be needed to pass the final bill -- Republican Susan Collins of Maine.

Another moderate Republican, Senator Scott Brown, was at the center of efforts to weaken the Volcker rule -- the ban on banks' proprietary trading first proposed by White House economic adviser Paul Volcker, according to aides.

Brown was poised to win carve-outs from the ban sought by mutual funds, insurers and banks in his home state of Massachusetts.

Senate negotiators have also fought to blunt the impact of new consumer-protection rules on small businesses, a key concern of moderate Republican Senator Olympia Snowe.

Wall Street has deployed an army of lobbyists to fight the measure. With the endgame at hand in Congress, their efforts may soon shift to the regulatory agencies that will put the new rules in place.

(Additional reporting by Roberta Rampton, Kim Dixon, Kevin Drawbaugh, Rachelle Younglai and Charles Abbott; Editing by Andrew Hay)

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