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Europe backs down in bid to tackle mega-banks

* Big banks grow despite financial crisis

* EU reform will not split their business

* Germany and France oppose any break up of big groups

By John O'Donnell

BRUSSELS, Jan 29 (Reuters) - Europe will unveil a blueprint to challenge the power of big banks on Wednesday but critics believe it will change little as it does not strictly separate multi-billion-euro market bets from savers' money.

After the collapse of Wall Street's Lehman Brothers in 2008, world leaders pledged to tackle banks that were "too big to fail". Yet throughout the crisis, many of Europe's top banks continued to grow.

On Wednesday, the European Commission will outline its proposals for a new law, including a ban on trading by banks using their own funds, which has already been much reduced.

It will also suggest isolating other types of trading from the 'safe' side of banking - taking deposits.

Even if agreement is reached, which is also in doubt, the rules would take effect from 2017 or later - roughly a decade after the start of the banking crisis in Europe and some two years after similar action in the United States.

The foot-dragging illustrates the fading political will to push tougher reform in the face of opposition from Germany and France, both determined to protect their flagship lenders.

Wolfgang Schaeuble, Germany's finance minister, said on Tuesday that he had urged the Commission to "think carefully" when drafting the new law.

Pressure from Paris and Berlin appears to have worked. Sven Giegold, an influential German lawmaker in the European Parliament, said Michel Barnier, the commissioner in charge of drafting the law, had backed down.

"Barnier couldn't bring himself to go up against France and Germany," he said. "The resulting law is bureaucratic and ineffective. Rather than saying certain types of business should be separated, there are loads of exceptions."

He and others believe the law will do little to address the vast scale of big banks, blamed for risky trading and growth in the multi-trillion dollar derivatives market.

The draft law draws on advice from a group lead by Finnish central bank governor Erkki Liikanen.

He suggested mandatory separation of banks' "proprietary" trading with their own funds, and other market betting, into a different legal entity. It would have its own capital to cushion risks but would remain within the bank.

On this count, the EU draft law is set to go further, and, like the Volcker Rule in the United States, ban banks from engaging in such trading, which has shrivelled in any case.

The U.S. rule, however, applies to all banks, while in the EU it will only apply to lenders above a certain size, taking in the top 30 or so banks.

In the EU draft, other types of trading, such as derivatives, should be put in a separate division.

Crucially, however, the EU law stops short of physically breaking up big banks into retail and wholesale units, a step critics say is needed to remove the too-big-to-fail threat.

France resisted interference in the structure of its big banks, including BNP Paribas and Credit Agricole , which Paris sees as "national champions" critical in financing the economy.

Berlin defended Deutsche Bank. It has total assets of more than 1.6 trillion euros - two thirds the size of Germany's economy - and lends to the country's top companies.