Banks looked increasingly likely to face some limits on swap trading as a proposal to rein in risky business practices gained traction among lawmakers negotiating a landmark Wall Street reform bill.

A revised proposal from Democratic Senator Blanche Lincoln was floated on Monday to allow banks to keep parts of their lucrative over-the-counter derivatives operations, a bid to mollify critics who had opposed a wide ban.

While the fresh proposal would allow banks to continue hedging their own risks in-house using swaps, it would still force banks to spin off lucrative swaps dealing activities.

Lincoln had initially proposed a plan that could have forced banks completely out of the $615 trillion OTC derivatives market. The plan, once seen as dead-on-arrival, had new life breathed into it last week after the Arkansas Democrat won a primary election in which she campaigned against banks.

A senior congressional aide said that portions, at least, of Lincoln's proposal will be incorporated in legislation expected to be finalized by the end of the month by a joint Senate-House of Representatives conference committee.

The panel will meet for the second time on Tuesday to consider new rules for private pools of capital and credit rating agencies.

Representative Barney Frank, the Democrat who is chairing the committee, on Monday called for dropping the Senate's most controversial plan to regulate credit rating agencies.

The Senate bill would create a board to match raters with debt issuers. The provision aims to mitigate conflicts of interests at the largest credit rating agencies -- Standard & Poor's, Moody's Corp and Fitch Ratings -- which are paid by the issuers whose debt they rate. Instead, Frank is proposing a study of credit rating agency reforms.

Frank also wants to ensure that advisers to hedge funds and private equity funds register with the Securities and Exchange Commission. The Senate bill exempts private equity funds from more oversight.

The back and forth is part of final negotiations on the biggest rewrite of U.S. financial rules since the 1930s.

Once approved by the committee and both chambers of Congress, the legislation would be sent to President Barack Obama to sign into law.

Enactment would give Obama and fellow Democrats a major domestic policy achievement to add to healthcare reform ahead of general elections in November. Voter anger at Wall Street has been a factor pushing Congress to act aggressively.

WIDE IMPACT OF LINCOLN PLAN

Lincoln's plan could have far-reaching impact for some of Wall Street's largest and more storied institutions.

The unregulated OTC derivatives market, including swaps, produced about $24 billion in industrywide revenues in 2009, with an estimated 98 percent of that total generated by JPMorgan Chase, Bank of America, Goldman Sachs, Morgan Stanley and Citigroup.

Amid concerns about profits being cut if the Lincoln plan and other reforms are approved, bank stocks fell on Monday as earlier broad gains on Wall Street were largely reversed.

Michael Greenberger, a professor at the University of Maryland School of Law, said banks would still face significant changes to their derivatives business under Lincoln's revised proposal, since they would have to find investors to separately capitalize the swaps entities, rather than backing the business with capital from the bank holding company.

They're going to have to go out and get people to put up capital for engaging in highly risky things, Greenberger said.

The bill under consideration presently contains Lincoln's initial proposal to force banks to choose between their lucrative OTC derivatives trading desks and access to government protections, such as emergency lending by the Federal Reserve.

White House economic adviser Paul Volcker, a former Fed chairman, told CNBC television on Monday that Lincoln's original proposal was too sweeping.

The proposed legislation ... has certainly taken account of some of the objections, he said.

According to a Senate aide, banks would only need to spin off swaps dealing activities to an arms-length affiliate under Lincoln's plan, but all swaps players, including exchanges and clearinghouses, would have access to emergency loans from the Fed.

The whole point behind this, I thought, was so that the derivatives business did not have access to government aid. So if you set them up separately then still give them access, I don't see what you've achieved, said Matthew Magidson, a lawyer at Lowenstein Sandler in New York.

(Additional reporting by Roberta Rampton, Charles Abbott, Caren Bohan, Kim Dixon and Andy Sullivan in Washington, and Steve Eder and Elinor Complay in New York; Editing by Leslie Adler)

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