Senate negotiators are slowly building a compromise proposal to overhaul the financial regulatory system, though significant differences continue to obstruct the path to a bipartisan Senate bill, said congressional and industry sources.

Bipartisan negotiators are working toward a possible resolution to the most contentious proposal: the creation of a new Consumer Financial Protection Agency.  The agency would write rules to govern, examine and enforce regulations on financial companies, with the goal of protecting consumers.  Democrats insist on its establishment and Republicans adamantly oppose a freestanding agency.     

The possible compromise would allow the government to create a new agency, but with limited powers.  An industry source said the banking lobby could “probably” support the proposal if state consumer protection laws could go no further than the new federal agency’s.  It is unclear if Democrats would agree to that and if such curbs on the consumer agency’s authority would be enough for Republicans to support the broader bill.   

Lawmakers on both sides agree the system needs better protections for consumers. One analyst worries the attention on the CFPA proposal has diverted the congressional focus and debate away from the most pressing financial regulatory fixes, like resolution authority and a regulator to monitor the entire financial system. 

“It’s not statutorily the same thing as … all of the kind of prudential issues that got us here,” said Karen Petrou, the managing director of Federal Financial Analytics, of the CFPA.  “It was written so broadly … it led to a lot of politics.”

Negotiators still face differences on how many types of derivatives contracts to exempt from higher regulatory standards and on a range of technical issues, said Senate Banking Committee and industry sources.

While members of the Senate Banking Committee debate, the Obama Administration continues to work on its latest financial regulatory proposal to ban proprietary trading by depository institutions.  Known as the Volcker Rule, it would prohibit riskier kinds of trading by banks with government-insured deposits.

Although the administration said it still supports the proposal, Federal Reserve Chairman Ben Bernanke gave it a tepid endorsement Wednesday.

“You have to be careful that you don't inadvertently, for example, prevent good hedging which actually reduces risk or that you don't prevent market making which is good for liquidity,” Bernanke told the House Financial Services Committee.  “One possibility … would be to give some discretion to the supervisors to decide whether a set of activities is so risky or complex that the firm doesn't have the risk management capacity or the managerial capacity to deal with it and then give the supervisor the authority to ban that activity.”

With similarly lackluster support among senators, lawmakers are discussing ways existing regulators can cut back on those risks without passing legislation implementing the Volcker Rule.

Treasury officials continue to guide and monitor the congressional process. On Wednesday afternoon, Treasury Secretary Tim Geithner met with the Senate Banking Committee’s top negotiators, Chairman Chris Dodd (D-Conn.) and junior Republican Sen. Bob Corker (R-Tenn.). 

About two weeks ago, the committee’s top Republican, Sen. Richard Shelby (R-AL), said he walked away from negotiations, prompting Dodd to announce he was writing a bill without Shelby.  Since then, Corker has stepped in for Shelby.  Despite the substitution, committee and industry sources said Shelby and his staff have remained engaged in negotiations. 

A representative for Sen. Dodd said she expects an agreement early next week.  Last week, his office said to expect a proposal this week.

Thursday, Geithner will brief financial industry lobbyists on the status of regulatory reform, said three sources whose organizations have been invited to the event. 

“They just asked us to come over.  We don’t have an agenda.  When the secretary calls, we go down there,” said an industry source.  “We want to get something done.”

Democrats, Republicans and banking lobbyists said they have a genuine commitment to upgrade an antiquated regulatory system in the wake of the financial crisis. 

Among other issues, industry lobbyists favor a way for the government to orderly take over and wind down a failing institution that threatens the health of the financial system and a “systemic risk” regulator for the entire financial system.  Bipartisan Senate negotiators have made significant progress on those items, a committee source said. 

“For all the agreement that we have, we all want something done,” said one industry source, insisting, as President Obama has, that the financial industry and system need regulatory certainty.