Merkel insists EFSF must be last resort for banks

BERLIN (Reuters) - German Chancellor Angela Merkel insisted on Friday the euro zone rescue fund should only be used to prop up banks as a last resort, ahead of a weekend meeting with French President Nicolas Sarkozy at which they are expected to thrash out how to strengthen the region's banks.

The 440 billion euro European Financial Stability Facility (EFSF) has been redesigned to help banks and buy up government bonds in an effort to beef up Europe's crisis fighting response.

Merkel told reporters after talks with Dutch Prime Minister Mark Rutte that they had both agreed that, if recapitalization were needed as now looks likely, this should be done according to a "hierarchy" of methods for raising the capital.

"The banks must first try to raise the capital themselves, if that doesn't work then the member state should come up with instruments as we did in 2008-2009, and only then when the country cannot cope on its own can the facility -- the EFSF -- be used," Merkel said.

Receiving such aid from the EFSF would involve the country in question agreeing to conditions including a program for structural reform, Merkel added.

"This will definitely be discussed at the next summit," said Merkel.

She stressed that the "philosophy" behind the EFSF -- which European leaders granted extra funding and powers to buy bonds and help banks in July -- was to stress both solidarity with struggling euro states but also the "willingness to reform of states that receive aid."

A German source said earlier that France, whose banks are exposed to the sovereign debt of struggling euro states, wanted to use the EFSF to recapitalize its banks. The source called this a French "misunderstanding" of how the fund works.

However, a French finance ministry source later said there was no disagreement between Paris and Berlin over how to bolster the capital of troubled European banks.

Merkel and Sarkozy are under pressure from financial markets and Washington to settle their differences on how to use the euro zone's financial firepower to resolve the debt crisis threatening the global economy.

Both leaders have reaffirmed in the last week that a Greek debt default must be avoided because it would have potentially catastrophic consequences for the European and global economy.

Merkel said European leaders were awaiting the findings of a team of EU and International Monetary Fund inspectors now in Athens monitoring its progress on reforms that are a condition for releasing an 8 billion euro aid installment by mid-November.

The German leader welcomed the Dutch parliament's approval late on Thursday of the enhanced EFSF and urged the remaining two euro zone countries who have not yet passed it -- Slovakia and Malta -- to do so and enable the fund to be implemented.

Merkel also gave her support to a Dutch proposal to create the new post of European Commissioner for the euro, saying she welcomed ideas to "improve the strength of the stability and growth pact" that underpins the single European currency.

(Additional reporting by Matthias Sobolewski; Writing by Stephen Brown; Editing by Toby Chopra)