The chairman of the Senate Banking Committee will unveil Tuesday his draft legislation to reform regulation of financial markets.

But the legislation from Sen. Christopher Dodd (D-CT) will be “challenged on arrival,” sources say. They predict it will be heavily compromised because of controversial provisions, lack of Republican support and significant differences with reform proposals moving in the House and with proposals from Obama Administration.

“This is just the starting point for Sen. Dodd and we expect him to compromise to get legislation through the Senate,” said Jaret Seiberg, financial services analyst with Concept Capital Washington Research Group in a note to clients. “As a result, we continue to believe the financial reform bill that emerges from the Senate will be more moderate than the legislation that the House is likely pass in December.”

One financial industry lobbyist said bluntly, “Dodd will have to twist a lot of arms to get the votes to get his bill out of committee.”

Sources say Dodd’s opening bid in the reform scramble is driven in part by real policy disputes with the House and Administration. Dodd, along with many other Democratic and Republican senators, blames the Federal Reserve for contributing to the recent financial crisis through lax bank regulation and weak consumer protections. Thus, Dodd will propose a more modest role for the Fed in his legislation.

But sources say politics is a factor in his positioning. He faces re-election in 2010 and is running behind Republican challengers in polls in Connecticut. Among other things, Dodd has been criticized for being too cozy with the financial services industry – he received a mortgage from Countrywide Financial under its “VIP” program, for example, though he was investigated and cleared by the Senate Ethics Committee.

As a result, industry sources say, Dodd – like some other senators facing the populist backlash over the financial crisis, government bailouts and continued industry bonus practices – has moved this year to embrace pro-consumer, bank-critical measures in regulation reform, credit card marketing and bank overdraft practices.

“He’s been in the Senate a long time and wants to stay, so keeping his seat has got to be a top priority,” said Karen Shaw Petrou, managing director of Federal Financial Analytics, a Washington, D.C., research and consulting firm. But, “everybody shifts because of politics,” she added.

According to industry sources, here are some of the key provisions of Dodd’s proposal:

    --A Consumer Financial Protection Agency. The CFPA would regulate sales and marketing of mortgages, credit cards and consumer loans. It is a key Administration proposal supported by Dodd’s counterpart in the House, Rep. Barney Frank (D-MA), chairman of the House Financial Services Committee, which recently approved legislation to create it. Financial firms and most Republicans oppose the idea, however, saying it would impose new costs and regulatory burdens on banks, especially small community banks, one of Washington’s most powerful business lobbies with members spread throughout states and Congressional districts. Some moderate Senate Democrats are wary of the idea for the same reasons. In the House, Frank gave small banks a partial exemption from CFPA regulation to win over wavering Democrats on his committee.

    --A council of financial regulators. The council would include the chairs of the Fed, Securities and Exchange Commission and the Federal Deposit Insurance Corporation, along with other supervisors; it would monitor risks to the financial system with “early warning systems,” to try to head off future financial crises. The council is another Administration idea supported by Frank. In both of their proposals, the Treasury Secretary would head the panel. But Dodd’s measure, sources say, would create an independent council chairman appointed by the president. Dodd’s legislation would also give more power to the council to monitor systematically important firms, sources said, while Frank and the Administration want the Fed to be the main systemic risk regulator. Dodd’s approach will face opposition from community bankers, among others. The International Community Bankers Association “strongly supports designating the Federal Reserve as the systemic-risk regulator,” the group said in a recent statement.

    --Resolution authority for the FDIC to take over, close, and wind down large, complex financial firms that fail. Both Frank and the Administration agree with this proposal, though they disagree on how to pay for it. The FDIC already handles failed banks; it charges the industry for the clean-ups through its deposit insurance fund, which banks support with ongoing quarterly premium payments. For takeovers of non-bank financial firms, Frank supports assessing Wall Street and other firms fees, to be paid into a resolution fund before any failures, similar to the FDIC premium model. The Administration, with industry support, favors assessing clean-up fees after a failure, in part to limit costs to firms and to discourage the perception that the government stands ready to rescue any failing firm, which it worries could encourage risky practices by firm managers and employees. But the Administration approach would require the use of taxpayer funds first in a new bailout -- the industry would later repay taxpayers through the fees. One industry source predicts that Dodd, with his pro-consumer bent, will support pre-payment of fees. Sources note that a pre-payment scheme would also limit public criticism that future rescues are taxpayer bailouts.

    --A single super bank regulator. This is Dodd’s most controversial proposal. It would strip the FDIC and the Fed of their bank supervision powers and place them into a new agency created by the merger of two other financial supervisors, the Office of the Comptroller of the Currency and the Office of Thrift Supervision. Both the Administration and Frank support the merger of the OCC and OTS. But the Administration considered and rejected the idea for a super regulator, judging it too politically difficult in the face of agency and industry opposition. In particular, small community banks oppose a super bank regulator, Petrou said. “They fear that would quickly be captured by a few large banking organizations,” she said. “They will fight hard, and I expect win a great deal back, to prevent a single consolidated bank regulator.”

Despite months of negotiations with the lead Republican on the banking committee, Sen. Richard Shelby (R-AL), Dodd will release his legislation without Republican support, sources said.

But Petrou expects Republicans to eventually support some of Dodd’s proposals. She called Dodd’s release of his draft legislation part of the “kabuki dance” between Democrats and Republicans on the banking committee.

“You have some lightning rod issues like the Consumer Financial Protection Agency that will be big political knock-down, drag out (fights),” she said. “You’ve got other issues like systemic risk regulation and resolution where there’s broad agreement.”

A moderate Democrat on the committee concurs. Sen. Mark Warner (D-VA), has been working with Republicans to find common ground on reform proposals.

“There's an awful lot of folks on both sides of the aisle that realize here we are a year after the worst financial crisis in our lifetimes and we should not let much more time go past before putting some new rules on the road, because it's great to see the Dow back at 10,000. But we're seeing, at least with some of these firms, some of the very kind of high-risk practices, high-risk trading that got us in the trouble in the first place still taking place without any additional oversight,” Warner said.

With the Administration’s urging, Dodd hopes to bring a reform package to a vote in December.