UPDATE 1-German cabinet agrees draft law on bank reform
* Law still needs to go through parliament
* Would limit risk-trading but not break up banks
* Law also foresees jail for reckless bankers
* Spinning off proprietary trading to affect up to a dozen banks - Schaeuble
* Opposition says plans are not far-reaching enough
By Annika Breidthardt and Matthias Sobolewski
BERLIN, Feb 6 (Reuters) - Germany plans to force up to a dozen banks to separate the riskier side of their business with a draft law that could send the reckless to jail but stops short of significantly disrupting key lenders.
The draft, approved by the cabinet on Wednesday, would push Germany ahead of international efforts to reform the banking system and prevent a repeat of the 2008 financial crash, even though the country may need to adjust once the European Union follows suit with pan-EU rules.
"It's a further step in our efforts to learn the lessons from the financial crisis of 2008 and 2009. We know the exaggerated deregulation of financial markets was a mistake," Finance Minister Wolfgang Schaeuble told reporters.
"No financial market, no financial actor, no financial product shall stay unsupervised," he added.
Under the draft law Germany would compel lenders to separate proprietary trading activities from retail banking, but only when assets associated with them exceed 100 billion euros ($135 billion) or 20 percent of the balance sheet.
On the basis of data from 2011, Schaeuble said that would affect 10 to 12 banks but declined to name them.
Lenders would still be allowed to trade on behalf of clients, conduct treasury activities and engage in market-making, a practice where financial institutions quote prices at which they will buy or sell securities.
The German draft includes provisions to imprison bank executives for up to five years if they are found guilty of reckless behaviour that puts a bank at risk.
The bank supervisor must also present plans on how banks might be restructured or wound down without using taxpayers' money.
The draft law is the latest in a string of measures by Chancellor Angela Merkel's government to regulate financial markets, following steps to limit managers' pays, ban short-selling and have banks pay into a resolution fund.
But with federal elections due in September, opposition politicians dismissed the plan as "a placebo", saying it is too soft on the bankers many blame for years of financial turmoil.
"Banks continue to be allowed to do highly risky business, and they will do so," said Joachim Poss, SPD deputy parliamentary floor leader.
Greens parliamentary floor leader Juergen Trittin said even Germany's flagship lender Deutsche Bank could live with the law. "It's a placebo with the purpose of election campaigning."
The upper house, or Bundesrat, where the main opposition parties, the Social Democrats (SPD) and the Greens, have a majority, can delay the law until the election, at which point it would die. Schaeuble said he hoped the law would be signed by June.
REGULATE - BUT HOW MUCH?
European countries are trying to strike a balance between popular calls for banks to be reined in and the risk that too tight a leash could choke off recovery.
But as EU legislation is likely to be presented only in September and could take years to come into force, individual countries have pushed ahead with their own regulation, and Germany's proposal leaned on similar French plans.
Critics say that is intended to spare German banks some of the tougher ring-fencing moves outlined by the Liikanen group, an EU advisory group, which four months ago unveiled reform proposals to shield taxpayers and savers from bank collapses.
Britain's finance minister, George Osborne, announced on Monday, for example, that British banks failing to shield their day-to-day banking from risky investment activities could be broken up.
Bankers have sought to cast doubt on whether the law would bolster financial stability.
"The draft law weakens Germany's financial centre and the time-tested German system of universal banks," said Andreas Schmitz, president of the German banking association.
Questioning the point of pushing ahead when European plans are still pending, he added: "Banking regulation is increasingly similar to a labyrinth from which nobody knows the exit."