BRUSSELS (Reuters) - European Union states backed on Tuesday a watered-down reform of regional supervision of money managers and other financial firms, top EU officials said, in a move that could leave open critical regulatory loopholes before Brexit.

FILE PHOTO: The Union Jack flag is adjusted before a meeting between British Prime Minister Theresa May and European Parliament President Antonio Tajani at the EU parliament headquarters in Brussels, Belgium February 7, 2019. REUTERS/Yves Herman

The plan, initially proposed by the EU executive Commission in 2017, was meant to avoid a situation under which, after Britain leaves the bloc, national regulators could offer sweeteners to London-based financial firms.

Smaller EU states had tried to completely block the reform, fearing it would reduce their power to attract foreign financial firms.

But after pressure from larger states led by France and Spain, a compromise was reached by EU finance ministers meeting in Brussels on Tuesday, an EU statement said.

The compromise, however, falls short of the initial plan proposed by the EU Commission.

Financial services commissioner Valdis Dombrovskis said the compromise “does not match the high level of ambition” of that proposal, but he added he could accept it as it was important to move forward with the reform.

Luxembourg was one of the EU states that most opposed the overhaul. The Grand Duchy’s finance minister Pierre Gramegna argued against changing the agreed text in talks with the European Parliament.

The tiny state is home to the euro zone’s largest investment fund industry, with nearly 4.5 trillion euros (£3.9 trillion) of assets, twice those of Germany, European Central Bank data show. Many of Luxembourg’s funds are headquartered in London.

Under the Commission’s plan, the EU markets watchdog ESMA would have directly supervised investment funds, such as venture capital and European Long-Term Investment Funds (ELTIF), but states blocked this reform.

They also thwarted a planned expansion of ESMA powers on monitoring prospectuses, which are documents containing the information needed before investing in a company.

The monitoring of national supervisors would also remain largely in the hands of a board of national authorities, instead of being carried out by an independent watchdog, as the Commission wanted.

One EU official said that, although the reform would increase transparency, some loopholes would remain. This would partly undermine the goal of preventing regulatory arbitrage after Brexit, the official said.

EU negotiators will now need to find common ground between governments and lawmakers for the reform to become law before EU Parliament elections in May.

Romania’s Finance Minister Eugen Teodorovici, who will conduct the talks on behalf of EU states, said negotiations with EU lawmakers would begin this week.

In January, the EU parliament adopted a much more ambitious text that would have given EU supervisors more clout.