* Britain to wave through ECB supervision after EUreassurances
* Time running out to agree scheme to tackle failing banks
* Germany's Schaeuble says taxpayers to be protected
By Robin Emmott and John O'Donnell
LUXEMBOURG, Oct 15 (Reuters) - Britain dropped itsobjections to granting the European Central Bank sweeping powersof supervision in the euro zone, but EU governments remaineddivided on Tuesday over how to deal with failing banks ahead ofa rapidly approaching December deadline.
Europe's finance ministers are striving to agree the nextbig step in European integration by setting up a bankingframework chiefly for the euro zone that would not only policethe bloc's banks but find joint solutions to their problems.
While ministers meeting in Luxembourg reassured Britainagain that ECB supervision from next year would not interferewith London's control of its financial centre, allowing Britainagree to the scheme, there was no agreement on anything else.
EU leaders, who meet next week in Brussels, have taskedtheir finance ministers with reaching a deal by the end of theyear on a euro zone agency to close or salvage failed banks, thesecond stage of an ambitious framework known as banking union.
Lawmakers in the European Parliament have already given theECB supervisory powers over the euro zone's 6,000 banks fromlate 2014, but such a role would lose much of its influencewithout an agency to deal with banks found to be in trouble.
With just 10 working weeks until the end of the year, thecomplex talks ran into Germany's long-held opposition toagreeing to an agency to deal with problem banks for fear thatBerlin will have to pick up the bill.
"Germany insists that the taxpayer is protected," GermanFinance Minister Wolfgang Schaeuble said, as he arrived at themeeting, reiterating that only a limited banking union could becreated without a change in the EU's basic law.
That is an anathema to France, Spain and Italy, which wantto see an immediate commitment by all countries in the 17-nationcurrency block to stand by weak banks regardless of where theyare.
In a new book to be published this week, France's FinanceMinister Pierre Moscovici accused Berlin of holding up progressto protect its own 'strange' financial system of regional banksthat are "deeply intertwined ... with local political circles".
Banking union, which many economists consider as importantas creating the euro currency more than a decade ago, aims tohelp countries deal with problems at banks before they get outof control.
Between 2008 and 2011, the European Union spent theequivalent of a third of its economic output on saving itsbanks, but relied on taxpayers' cash. In the case of Ireland,reckless bank lending almost bankrupted the country.
The issue of how to pay for bank clean-ups is pressing asIreland and Spain prepare to end their reliance on internationalaid that shored up their banks, concluding programmes thatneither Dublin nor Madrid plan to renew.
EU leaders are eager to trumpet Ireland and Spain as successstories after the four years of economic turmoil that started inGreece when Athens revealed its massive overspending and plungedthe currency bloc into a crisis that threatened its survival.
While the ECB's promise to buy government bonds calmed thepanic about the euro's future, many banks are still sitting on amountain of loans that may go unpaid.
The International Monetary Fund estimates Spanish andItalian banks alone face 230 billion euros ($310 billion) oflosses on credit to companies in the next two years.
Before taking on its supervisory role, the ECB will conducta series of health checks on the euro zone's 130 biggest banksnext year, seen as the last chance for the bloc to come clean onlosses that have festered throughout the financial crisis.
"This is fundamental and the tests have to be serious, withstrict, rigorous scenarios," Spanish Economy Minister Luis deGuindos told reporters.
During the sovereign debt crisis, the European Unionconducted two bank tests that were considered flops for blunderssuch as giving a clean bill of health to Irish banks monthsbefore they pushed the country to the brink of bankruptcy.
The new round of tests will be tougher. But uncoveringproblems poses the difficult issue of who pays to salvagefailing banks or close them down.
It remains unclear to what extent the euro zone's rescuefund, the European Stability Mechanism, will be able to helpindividual banks directly without making their home governmentsresponsible for repaying the aid.
"Direct recapitalisation could be possible," said JeroenDijsselbloem, who chairs the meetings of euro zone financeministers, hinting, however, that some countries did not sharethis view.
"It would be under the strictest conditions and we aretalking about exceptional circumstances."
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