Key senators are expected to scrap President Barack Obama's proposal to prohibit commercial banks from certain risky trading activities, people familiar with the matter said, a setback for the administration's bid to limit the size and scope of the largest U.S. banks.
The proposal, dubbed the "Volcker rule" after former Federal Reserve Chairman Paul Volcker, would have essentially prevented any commercial bank with federally insured deposits from owning a division that makes speculative bets with its own capital.
But after resistance from lawmakers from both parties, Senate Banking Committee Chairman Christopher Dodd (D., Conn.) and other legislators are expected to introduce a plan next week that would give regulators more discretion to limit and potentially ban risky trading at banks, especially if it poses a risk to the broader economy. The measure would stop short of banning such trading outright.
The Senate bill is expected to direct regulators to pay particular attention to "proprietary trading"-whereby a bank trades stocks, bonds or other financial instruments with its own money-which the White House wants to ban at commercial banks. Under the proposal, regulators would examine banks on a case-by-case basis and would be able to direct them to limit or halt certain activities they felt were a systemic risk. Such activities were banned under Depression-era laws requiring the separation of commercial and retail banking activities but those rules were rolled back in the 1990s.
Mr. Volcker, who has advised Mr. Obama on economic policy, has said allowing banks to make bets with capital subsidized by the federal government could pose such a risk. Mr. Volcker didn't return a message seeking comment. A spokeswoman for Mr. Dodd said a final decision hasn't been made yet.
The White House introduced the Volcker rule in January as part of its broader proposal to overhaul financial regulations in the wake of the financial crisis, but that package is now being dialed back by lawmakers. As part of that broader plan, the White House wants to create a Consumer Financial Protection Agency to police mortgages and credit cards.
Sen. Bob Corker (R., Tenn.), also a member of the Senate Banking Committee, has opposed the agency, and Mr. Dodd is exploring whether a new consumer division could instead be created within the Treasury Department, people familiar with the matter said.
Mr. Dodd is negotiating a range of issues with Mr. Corker including how to address troubled financial companies and regulating financial derivatives. Several people close to the negotiations said both lawmakers are optimistic a broader deal could be reached. But Mr. Corker has raised reservations about the proposed "Volcker rule," saying it was introduced to satisfy populist anger against Wall Street and not because the White House thought it was good policy.
The White House proposal came two days after voters in Massachusetts elected Scott Brown to the Senate seat once held by Edward Kennedy.
But few people now expect the concept to be included in the financial-overhaul legislation, in large part because the White House hasn't spelled out to Congress exactly how a ban on proprietary trading would work, said people familiar with the process.
The provision in its original form, if enacted, could force companies such as Goldman Sachs Group Inc., Morgan Stanley and J.P. Morgan Chase & Co. to shed certain divisions or reorganize their business practices. It has won support from several former Treasury secretaries but triggered a violent reaction on Wall Street, helping send the Dow Jones Industrial Average into a three-day slide after its announcement.
White House and administration officials say they stand by the proposal as originally presented. There's still a chance lawmakers could add amendments later in the process.
"As an administration, we're as committed to the rule as the day the president announced it," White House senior advisor David Axelrod said, echoing a comment from the Treasury Department. "It was presented as a solution to address a problem that the president perceived. There's no diminution of concern about the problem" of proprietary trading by banks.
The modified language senators are considering is similar to a rule in financial-overhaul legislation passed by the House last year. Banks contend the language is unnecessary, in part because regulators already have discretion to stop banks from certain practices.
Rep. Paul Kanjorski (D., Pa.), a senior Democrat on the House Financial Services Committee, said in an interview that the new powers needed to be spelled out.
"We want to clearly delineate...this is what you should do,"' he said.
Bob Davis contributed to this article.