A U.S. senate committee will consider whether to drop a controversial idea to ban banks from the swaps market in a debate on derivative reform on Wednesday, as efforts to toughen regulation head into the home straight.

The hearing on the Agriculture Committee's swaps bill will be a test of how tough Democrats are willing to be on the complex financial instruments dominated by Wall Street firms -- and how gingerly Republicans tread around a populist issue ahead of November elections.

Similar to a broader Banking Committee package that is set for a full Senate debate by next week, the bill would regulate the $450 trillion swaps market for the first time, requiring most derivatives to trade on exchanges and pass through clearing houses to prevent risky trades from ricocheting through the economy, as happened during the financial crisis.

But Agriculture Committee Chairman Blanche Lincoln took an even harder line last week, shocking the market by including a measure that would require banks participating in the swaps market to give up protections like access to the Federal Reserve discount window -- a potentially devastating blow for banks' hugely lucrative swaps trading desks.

It was the latest salvo in a barrage of tough measures meant to crack down on Wall Street for excessive risk-taking that precipitated the recession.

On Friday industry leader Goldman Sachs was charged with fraud by the Securities and Exchange Commission for misrepresenting a subprime debt produce, while the International Monetary Fund on Tuesday proposed two new taxes on banks worldwide as a way to deter risky behavior.

RESISTANCE SOFTENS

Under mounting pressure not to impede the crack-down, Republican lawmakers -- at least one of whom needs to join Democrats in order to overcome procedural hurdles -- appeared on Tuesday to soften resistance to greater regulation. President Barack Obama will seek to drum up more support with a visit to the U.S. financial capital New York City on Thursday.

After discussion of potential amendments, Lincoln's bill is expected to pass the committee on Wednesday, becoming part of Banking Committee Chairman Christopher Dodd's broad regulatory reform plan which could be debated next week.

Lincoln has shown little inclination toward compromise, but may need to bend in order to woo Republican support. On Tuesday House Democratic Leader Steny Hoyer said that a controversial fund designed to help pay for dismantling troubled financial firms was not central to the bill.

If you're going to be a bank, and you want to be a bank, then you need to be a bank, and you need to spin off the swaps activity, the risky activity that exists out there, Lincoln told reporters on Tuesday, defending her draft.

Staffers worked late into the night on Tuesday on technical corrections to the draft bill, and Lincoln may offer a package including some changes, a committee aide told Reuters, noting the scope of the changes was still unclear.

The bill is being closely watched by firms that dominate the unregulated swaps market, like Goldman Sachs, JPMorgan Chase, Morgan Stanley, Citigroup and Bank of America.

Lincoln's bill is also important for smaller firms that count on derivatives to hedge their risk -- they account for about 10 percent of the market.

A coalition of so-called end users praised aspects of Lincoln's bill, which more clearly defines that some smaller players won't be subject to some of the more costly rules.

But the group is still hoping for a raft of changes, including a broader list of companies exempt from clearing trades. It also believes banks should not have to spin off swaps desks, said Dave Hall, who works with the coalition.

If banks are forced to get rid of their swaps businesses, then there may be no one for end users to do their swaps with, said Hall, chief operating officer of Chatham Financial, an interest rate and currency risk management advisor

(Additional reporting by Charles Abbott and Christopher Doering; editing by Patrick Graham)

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