* Dealing with bust banks crucial step in banking union
* Euro zone ministers meet to discuss who pays for clean up
* France's Moscovici blames Germany for holding up project
By John O'Donnell and Robin Emmott
LUXEMBOURG, Oct 14 (Reuters) - The euro zone debated onMonday how to prop up banks likely to be declared unstable nextyear, but France's blunt criticism of Germany before the meetinglaid bare the tensions surrounding the far-reaching financialreform.
Bank health checks by the European Central Bank are acritical step in establishing a single banking framework for theeuro zone, giving credibility to ECB supervision and paving theway for the bloc to cooperate on saving bust banks.
But even before ministers from the 17-nation currency areamet in Luxembourg, France's finance minister accused Germany ofholding up progress on banking union to protect its own'strange' financial system of regional banks that are "deeplyintertwined ... with local political circles".
"What Germany fears ... is ... a loss of political controlover its banks, which means in the final analysis a loss ofsovereignty," Finance Minister Pierre Moscovici wrote in a bookto be published this week called "Battles to resurrect France".
"It just goes to show that the champions of Europeanintegration and political union are not always those who appearto be. That's why banking union is being built so slowly andwith such difficulty," he wrote.
There was no immediate reaction from Berlin as Germany'sfinance minister, Wolfgang Schaeuble, did not attend the firstday of the two-day meeting because of talks to form a new Germangovernment.
The acrimony between the euro zone's two largest economieswill complicate EU efforts to strike a deal by December on howto salvage failed banks, as set out by Europe's leaders.
Such a failure would put the ECB out on a limb when itbegins supervision of euro zone banks late next year, withoutany means to shut or save banks in trouble.
Although nobody knows the true scale of potential losses atEurope's banks, the International Monetary Fund hinted at theenormity of the problem this month, saying that Spanish andItalian banks face 230 billion euros ($310 billion) of lossesalone on credit to companies in the next two years.
The discord helps explain why five years after the UnitedStates demanded its big banks take on new capital to reassureinvestors, Europe is still struggling to impose order on itsfinancial system, having given emergency aid to five countries.
During the region's debt turmoil, the European Unionconducted two bank stress tests, 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 ECB's new checks are seen as the last chance to comeclean for the euro zone as the bloc tries to set up bankingunion, a bold step in European integration.
"Our priority is to break the funding link between thesovereign and the balance sheets of banks," said PaschalDonohoe, Ireland's Europe minister, as he arrived for themeeting in Luxembourg. "A credible, robust banking union,delivered on time, is essential to doing this."
Late last week, European Central Bank President Mario Draghiunderscored the need for publicly funded back-ups torecapitalise banks, saying those must be in place before itsreview of banks' health, expected early in 2014.
But Germany and Finland want individual states to pick upthe costs of any clean-up rather than resort to the euro zone'srescue fund, the European Stability Mechanism.
"For now, we should rely on national backstops, meaning thatif needed, national governments would step in," Finland'sFinance Minister Jutta Urpilainen told reporters.
With the euro zone barely out of recession, a failure to putaside money to deal with the problems revealed could rattlefragile investor confidence and compound borrowing difficultiesfor companies, potentially killing off the meek recovery.
It raises the awkward question: who pays for the holes foundin balance sheets in countries such as Spain and Italy?
This time around, the task of cleaning up banks should notbe quite as daunting as five years ago because shareholders,bondholders and wealthy depositors can expect to take some ofthe losses, as happened in the bailout of Cyprus in March.
But if that is not enough, it will fall to governments topick up the tab.
The debate opens amid ebbing political enthusiasm forbanking union - originally planned as a three-stage processinvolving ECB bank supervision, alongside an agency to shutfailing banks and a system of deposit guarantees.
In one sign of the divisions, Britain has repeatedly refusedto sign off on the first pillar of the banking union framework,allowing the ECB monitor banks.
Having earlier agreed, London now wants additionalassurances from ministers this week that Britain, which isoutside the euro and polices its own banks, will not faceinterference from the ECB-led euro bloc.
Britain is likely to find a sympathetic ear in Berlin, whichwants to keep London on side in its push to prevent stricter EUemissions rules to protect its luxury car makers.
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- European Central Bank