British blessing fails to break banking union impasse

* Britain to wave through ECB supervision after EU reassurances

* 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 its objections to granting the European Central Bank sweeping powers of supervision in the euro zone, but EU governments remained divided on Tuesday over how to deal with failing banks ahead of a rapidly approaching December deadline.

Europe's finance ministers are striving to agree the next big step in European integration by setting up a banking framework chiefly for the euro zone that would not only police the bloc's banks but find joint solutions to their problems.

While ministers meeting in Luxembourg reassured Britain again that ECB supervision from next year would not interfere with London's control of its financial centre, allowing Britain agree to the scheme, there was no agreement on anything else.

EU leaders, who meet next week in Brussels, have tasked their finance ministers with reaching a deal by the end of the year on a euro zone agency to close or salvage failed banks, the second stage of an ambitious framework known as banking union.

Lawmakers in the European Parliament have already given the ECB supervisory powers over the euro zone's 6,000 banks from late 2014, but such a role would lose much of its influence without an agency to deal with banks found to be in trouble.

With just 10 working weeks until the end of the year, the complex talks ran into Germany's long-held opposition to agreeing to an agency to deal with problem banks for fear that Berlin will have to pick up the bill.

"Germany insists that the taxpayer is protected," German Finance Minister Wolfgang Schaeuble said, as he arrived at the meeting, reiterating that only a limited banking union could be created without a change in the EU's basic law.

That is an anathema to France, Spain and Italy, which want to see an immediate commitment by all countries in the 17-nation currency block to stand by weak banks regardless of where they are.

In a new book to be published this week, France's Finance Minister Pierre Moscovici accused Berlin of holding up progress to protect its own 'strange' financial system of regional banks that are "deeply intertwined ... with local political circles".

Banking union, which many economists consider as important as creating the euro currency more than a decade ago, aims to help countries deal with problems at banks before they get out of control.

Between 2008 and 2011, the European Union spent the equivalent of a third of its economic output on saving its banks, but relied on taxpayers' cash. In the case of Ireland, reckless bank lending almost bankrupted the country.


"FUNDAMENTAL" TESTS

The issue of how to pay for bank clean-ups is pressing as Ireland and Spain prepare to end their reliance on international aid that shored up their banks, concluding programmes that neither Dublin nor Madrid plan to renew.

EU leaders are eager to trumpet Ireland and Spain as success stories after the four years of economic turmoil that started in Greece when Athens revealed its massive overspending and plunged the currency bloc into a crisis that threatened its survival.

While the ECB's promise to buy government bonds calmed the panic about the euro's future, many banks are still sitting on a mountain of loans that may go unpaid.

The International Monetary Fund estimates Spanish and Italian banks alone face 230 billion euros ($310 billion) of losses on credit to companies in the next two years.

Before taking on its supervisory role, the ECB will conduct a series of health checks on the euro zone's 130 biggest banks next year, seen as the last chance for the bloc to come clean on losses that have festered throughout the financial crisis.

"This is fundamental and the tests have to be serious, with strict, rigorous scenarios," Spanish Economy Minister Luis de Guindos told reporters.

During the sovereign debt crisis, the European Union conducted two bank tests that were considered flops for blunders such as giving a clean bill of health to Irish banks months before they pushed the country to the brink of bankruptcy.

The new round of tests will be tougher. But uncovering problems poses the difficult issue of who pays to salvage failing banks or close them down.

It remains unclear to what extent the euro zone's rescue fund, the European Stability Mechanism, will be able to help individual banks directly without making their home governments responsible for repaying the aid.

"Direct recapitalisation could be possible," said Jeroen Dijsselbloem, who chairs the meetings of euro zone finance ministers, hinting, however, that some countries did not share this view.

"It would be under the strictest conditions and we are talking about exceptional circumstances."