Banks would face stricter limits on risky trading and investing, but could make small investments in private equity and hedge funds under a modified Volcker rule backed by U.S. lawmakers on Thursday.

In a victory for banks that had lobbied for a limited loophole on fund investing to be included in landmark Wall Street reform legislation, a Senate-House of Representatives panel agreed to make changes to the controversial rule.

Senator Christopher Dodd proposed that up to 3 percent of a bank's Tier 1 capital could be invested in private equity and hedge funds, and that a bank's investment in any single fund not exceed 3 percent of the fund's total ownership interest.

Those thresholds were backed by both the Senate and House delegations to the conference committee and will be included in the final bill if it is finally approved. It was still being debated into the wee hours on Friday morning by the panel.

Banks would have considerable time to sell off stakes in such funds that exceed the new caps, and to make other changes to adjust to the Volcker rule, which is named after White House economic adviser Paul Volcker and backed by the White House.

Some of Wall Street's largest financial institutions, such as Goldman Sachs, JPMorgan Chase, Credit Suisse and Citigroup have been deeply involved in private equity deals and could face changes, analysts said.

The Volcker rule could have been a lot worse for the banking sector than the version distributed this evening. This version will still hurt profitability and impact business decisions. But it is not the knock-out blow some had feared, said Concept Capital policy analyst Jaret Seiberg.

Lobbyists for Bank of New York Mellon, State Street Corp and Northern Trust Co were especially active in pressing for exemptions to let their asset management units continue to make small, or 'de minimis,' investments in private equity and hedge funds, congressional aides said.

COMPLETION TARGETED

Lawmakers hoped to finish the overall bill on Friday. If they can, the bill would need to pass both the Senate and the House before it could go to President Barack Obama to be signed into law. Democrats want that to happen before July 4.

Dodd's proposal toughened the rule along lines suggested by Democratic senators Jeff Merkley and Carl Levin that would give regulators less leeway in implementing it and require non-bank firms that do risky trading to hold more capital.

The rule would bar banks from doing proprietary trading for their own accounts that is unrelated to the needs of their customers. Its aim is to insulate core banking operations from riskier trading operations at financial institutions that are backed by government deposit insurance and in other ways.

Democratic Senator Jack Reed said the rule would insulate the core bank from investments in private equity and hedge funds. We've built in some strong protections, Reed said.

A new interagency Financial Stability Oversight Council, also proposed as part of the overall legislation, would have to study the Volcker rule and regulators would have nine months after that to implement it. Financial services firms would have a year to comply with the new rules after they are issued.

This proposal addresses the underlying concern of putting depository funds at risk. ... It puts a stop to proprietary trading, but also recognizes that there are legitimate hedging activities that banks need to engage in, Dodd said.

Dodd had said earlier in the negotiating session on Thursday that the cap on banks' fund investments be 3 percent of tangible common equity. Later, he changed it to Tier 1 capital, a measure of a bank's core capital strength.

(Reporting by Kevin Drawbaugh, Andy Sullivan, Kim Dixon and Rachelle Younglai, editing by Jackie Frank)

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