Senate Banking Committee Chairman Christopher Dodd, in charge of shepherding reform legislation through the Senate, has introduced a bill aimed at preventing a recurrence of the 2008 financial crisis that shook economies worldwide.
Dodd's bill met opposition from Republicans on his panel. Lawmakers from both parties are tearing the measure apart to find consensus on how to regulate everything from banks to the $450-trillion over-the-counter derivatives market.
But there is broad agreement among committee members to curb the Fed after it intervened repeatedly in the financial crisis to help troubled firms like insurer AIG.
Committee members have charged the Fed with lax regulation, failing to prevent the economic crisis, and misusing billions of dollars in taxpayer funds to prop up financial firms.
Members agree the Fed should be confined to monetary policy and being lender of last resort. So it should not be directly supervising banks, the two people said.
The sources requested anonymity because the bill is in flux and has not been made public.
Under such an arrangement, the Fed would be stripped of its duties to directly examine and supervise bank holding companies such as Citigroup Inc, Goldman Sachs, Morgan Stanley and Bank of America, the sources said.
A House of Representatives regulatory reform bill approved on December 11 does not strip the Fed of its supervisory powers.
House Financial Services Committee Chairman Barney Frank has advocated ending the Fed's consumer protection role, but has been adamant it needs to keep bank regulation powers.
Both Senate and House bills would have to be reconciled into a single measure before legislation could be sent by Congress to President Barack Obama to sign into law. That could happen in April or May, policy analysts said.
Senate Banking Committee members agree there should be a mechanism in place to unwind troubled financial firms to avoid a repeat of 2008, when the government improvised and dealt with troubled firms like AIG and Lehman Brothers very differently.
That is in keeping with an Obama administration financial regulation plan. The White House is pushing for so-called resolution authority, or giving the government the power to shut down a troubled firm and force creditors and shareholders to assume losses.
Dodd's draft bill would give the Federal Deposit Insurance Corp. primary authority to break up troubled firms.
It was unclear whether Republicans agree on bolstering the FDIC's powers. But there is agreement that the cost of unwinding a firm should be recouped after the rescue and not before, the sources said.
Again, the House bill takes a different approach, calling for creating a $200-billion fund to pay for FDIC actions.
One provision in limbo in the Senate committee is the proposed creation of an agency to protect consumers from potentially risky financial products like subprime mortgages.
The Consumer Financial Protection Agency is one of the administration's key proposals. Republicans, including the party's top committee member Richard Shelby, oppose it.
The sources said the consumer agency is being left as the last negotiating point because it is so contentious.
Republicans will not vote for a bill that includes the agency as the White House proposed, one of the sources said.
Shelby and Dodd have said they hope to reach a deal on financial reform before the Senate reconvenes on January 20.
(Reporting by Rachelle Younglai; Editing by Andrew Hay)