UPDATE 2-European Union breaks deadlock on bank rules
* Tougher capital standards needed to prevent new crisis
* Hard-line Britain compromises on capital rules
* Britain's Osborne says reform is key to beef up Europe's banks
By John O'Donnell and Matt Falloon
BRUSSELS, May 15 (Reuters) - EU finance ministers agreed on tougher capital rules for banks on Tuesday, resolving years of sparring between Britain and the rest of the European Union over how best to craft measures to prevent another financial crisis.
Acknowledging the depth of the recent euro zone difficulties that have driven Spain to take over lender Bankia and prompted a sweeping credit downgrade of Italy's banks, British finance minister George Osborne dropped earlier objections and threw his weight behind the draft law.
He had previously accused his EU peers of trying to dilute globally agreed capital rules to the point where they would make him "look like an idiot".
The deal paves the way for regulations effective from next year aiming to make the 27-member bloc's 8,300 banks safer. It makes it more expensive for banks to lend, by demanding they hold more capital to cover potential losses on loans.
"We are reaching a point where we have got to make a decision to see the euro zone stand behind their currency," Osborne told reporters. "A very important part of that is strengthening the entire European banking system."
"The rest of the world is paying very close attention to how strong European banks are," he later told finance ministers.
How much capital should be set aside to cover banking risks is a central question raised by five years of financial sector difficulties in which dozens of banks fell in Europe.
The compromise also helped to avert a worsening of relations between Britain and the rest of the bloc, after Prime Minister David Cameron blocked plans by other EU members in December to change an existing treaty to enforce budget controls.
Britain, which had demanded concessions on the capital rules to protect London's autonomy in controlling its financial sector, won leeway to set stricter standards than the EU norm, but will need permission from Brussels above certain levels.
German Finance Minister Wolfgang Schaeuble called the agreement a "significant" step in reforming finance.
In recent days, Osborne had been alone among the 27 European Union finance ministers in calling for changes to the law.
As Osborne and his advisers departed for the train from Brussels to London, one of his aides said: "In the UK, we will now be able to implement our own banking changes, as we wish."
BRUSSELS OR LONDON?
Higher capital buffers strengthen banks to withstand shocks, such as the slump in property prices or recession now hitting Spain. And banks with higher-than-average capital, such as Switzerland's UBS, have increased attraction for depositors.
Holding more capital could also help banks resist contagion if financial markets were to shun a particular country in the bloc and it needed emergency funding.
Far more than the details in banks' balance sheets, the dispute over the rules was a struggle for influence and power in a bloc shaken by the worst financial crisis in generations.
Britain has been fighting to maintain its authority over the City of London, Europe's financial capital, as other EU members move to centralise supervision and regulation of banking and finance.
It also wanted the right to ensure its banks are safe, having bankrolled the 46-billion-pound rescue of Royal Bank of Scotland, the biggest bailout of the financial crisis.
Osborne has argued that Britain, not the European Commission, should decide, as it would have to bear the financial consequences of a bank bailout.
Financial services account for about 9 percent of the UK economy, almost as much as its entire manufacturing sector.
Under the agreement, Britain would be able to raise a bank's minimum capital from the 7 percent core tier 1 ratio - set by the so-called Basel III code - to 10 percent, even if this affects a bank's subsidiaries in neighbouring countries.
Above this, it may need approval from the European Commission.
Britain is also allowed to force banks to temporarily boost their capital beyond this level without asking for permission.
Osborne also dropped objections to measures including the recognition of a form of shareholder capital often used for German regional landesbanks that he believed waters down the Basel regulatory standards in EU law.
Countries will now have to negotiate a final version of the law with the European Parliament. Many of its legislators want to have more EU control over how countries levy additional capital demands.
Europe's capital regime, when decided, will be closely studied in the United States and may influence how policymakers there interpret the Basel norms.