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. Senate Democrats on Thursday.

In a victory for financial institutions that had pushed for a fund-investing loophole in the bill, the head of the Senate's negotiating team on a panel writing landmark Wall Street reform legislation proposed changes to the controversial rule.

Democratic Senator Christopher Dodd proposed that up to 3 percent of a bank's tangible common equity could be invested in such funds, but that a bank's investment in any one fund could not exceed 3 percent of the fund's total ownership interest.

Banks would have some time to sell off stakes in private equity and hedge funds that exceed the new caps, he said.

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.

One goal of these limits is to reduce participation in high-risk activity that can cause significant losses at institutions which are central to the financial system, Dodd told the joint Senate-House of Representatives panel.

The House team on the panel must react to Dodd's proposal.

He further proposed toughening the Volcker rule -- named after White House economic adviser Paul Volcker -- to give regulators less leeway in implementing it and requiring non-bank firms that do risky trading to hold more capital.

The Volcker rule, backed by the Obama administration, would bar banks from doing proprietary trading for their own accounts that is unrelated to the needs of their customers.

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.

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, Dodd proposed.

Financial services afirms would have a year to comply with the new rules after regulators issue them, he said.

Tangible common equity is a measure of a bank's or financial firm's capital that ignores intangible assets such as goodwill.

(Reporting by Kevin Drawbaugh, Andy Sullivan, Kim Dixon and Rachelle Younglai; Editing by Jan Paschal)