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Richard Shelby, the top Republican on the Senate Banking Committee that must back the legislation, said the draft bill requires a "complete rewrite" and that Republicans will offer a substitute.

The bill unveiled last week by Senate Banking Chairman Christopher Dodd would create a super cop to police U.S. banks and create new agencies to oversee risk in the financial system and consumer protection.

In an attempt to ensure that no single financial firm is too big to fail, the bill would give regulators the power to break up large, complex companies if they pose a threat to the financial system.

Shelby told a banking committee hearing on the Democratic bill that he agreed with some of its goals -- such as limiting the role of the Federal Reserve and shedding light on the $450 trillion over-the-counter derivatives market.

However, Shelby criticized other aspects of it. "The Dodd bill does not end 'too big to fail,'" he said. "It significantly expands the federal government's ability to bail out not only banks, but any large politically connected company."

The government has used tens of billions of dollars in taxpayer funds to backstop firms that were considered a risk to the economy, including insurer AIG () and Bank of America ().

Dodd's legislation would give the Federal Deposit Insurance Corp authority to unwind troubled financial firms, with the cost of dismantling them recouped later by assessments on other firms.

Key lawmakers believe this would help squash a market belief that the government will always prop up financial firms whose global reach has the potential to destabilize markets.

(Reporting by Rachelle Younglai; Editing by Tim Dobbyn)