Franco-German divisions cloud efforts to fix broken banks

* Dealing with bust banks crucial step in banking union

* France's Moscovici warns against 'weak' reform

* Euro zone ministers wrestle with who pays for clean-up

By John O'Donnell and Robin Emmott

LUXEMBOURG, Oct 14 (Reuters) - The euro zone wrestled on Monday with the question of who should pay for a clean-up of bust banks, as Franco-German divisions cast a cloud over efforts to seal a landmark reform and draw a line under the region's financial crisis.

As Spain and Ireland prepare to end their reliance on international aid that shored up their banks, finance ministers sought to devise a long-term action plan to deal with problems likely to be uncovered in bank health checks next year.

Issues remained over how much the euro zone's rescue fund, the European Stability Mechanism, will be able to help, as well as over how to build a single banking framework for the bloc and resolve future problems together in a banking union.

"It is a priority, an essential project," France's Finance Minister Pierre Moscovici told reporters after the meeting in Luxembourg. "A weak banking union is not a banking union."

France is leading a group including Spain and Italy in demanding that the ESM, established to provide financial help to euro zone governments, act as a clear backstop for unstable banks in the euro area, in time for when the European Central Bank's health test results are announced some time in 2014.

Germany, Europe's largest economy, along with the Netherlands and Finland want conditions attached to any ESM involvement to prevent the clean-up costs being foisted on them.

"France defends the possibility of using the European Stability Mechanism as a backstop within the banking union," Moscovici said.

Bank health checks by the European Central Bank are a critical step in establishing a single banking framework for the euro zone, giving credibility to ECB supervision and paving the way for the bloc to cooperate on saving failing banks.

The divisions in the 17-nation currency area were underlined by Moscovici's blunt criticism of Germany before the meeting.

In a new book to be published this week, he accused Berlin of holding up progress on banking union to protect its own 'strange' financial system of regional banks that are "deeply intertwined ... with local political circles".

"What Germany fears ... is ... a loss of political control over its banks, which means in the final analysis a loss of sovereignty," Moscovici wrote in "Battles to resurrect France".

Germany's finance minister, Wolfgang Schaeuble, was not present because of talks to form a new German government.

To complicate matters further, Britain, which is outside the euro zone, has repeatedly refused to sign off on the first pillar of banking union, the supervision.

London has demanded assurances that Britain will not face interference from the ECB-led banking union.


Asked to outline the hurdles that remain on banking union, Jeroen Dijsselbloem, who chaired the meeting of euro zone finance ministers, replied: "How much time do you have?" before listing a range of issues such as establishing a fund and agency to close or salvage troubled banks.

The acrimony between the euro zone's two largest economies, France and Germany, will complicate EU efforts to strike a deal by December on how to salvage failed banks, as set out by Europe's leaders to give time for the agreement to be signed into EU law in 2014.

A failure to do so would put the ECB out on a limb when it begins supervision of euro zone banks late next year, without any means to shut or save banks in trouble.

Although nobody knows the true scale of potential losses at Europe's banks, the International Monetary Fund hinted at the enormity of the problem this month, saying that Spanish and Italian banks face 230 billion euros ($310 billion) of losses alone on credit to companies in the next two years.

Dijsselbloem said ESM direct aid for banks would only be available under strict conditions, and could not say if this possibility would be ready in time for the bank health checks.

Ending their meeting, the ministers restated the urgent need for progress but acknowledged the breadth of differences that must be overcome. The debate continues on Tuesday when ministers from the wider European Union gather.

With the euro zone barely out of recession, a failure to put aside money to deal with the problems revealed could rattle fragile investor confidence and compound borrowing difficulties for companies, potentially killing off the meek recovery.

The discord helps explain why five years after the United States demanded its big banks take on new capital to reassure investors, Europe is still struggling to impose order on its financial system, having given emergency aid to five countries.

The debate also comes at a delicate moment for the euro zone, with Spain and Ireland planning to end their reliance on the aid that was given to save their banks. Question marks remain over both countries and the true health of their banks.

Ireland's banks, which nearly drove the country into bankruptcy three years ago, face further losses, with increasing numbers of homeowners falling behind in repaying their loans as the economy continues to stagnate.

Olli Rehn, the EU's Economic and Monetary Affairs Commissioner, sought to play down those concerns, however, saying: "Let's not jump the gun. Let's first establish the facts... And in the meantime, don't speak loosely."

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