UPDATE 1-Europe's banking union ambitions under strain
* Spain's De Guindos says banking union vital to euro's future
* Sweden's Borg says compromise to reach deal possible
* Austria's Fekter sees compromise on scope of ECB supervision
By John O'Donnell and Robin Emmott
BRUSSELS, Dec 4 (Reuters) - Divisions over how European bank oversight will work threaten to undermine one of Europe's boldest reforms as finance ministers finalise plans to put the European Central Bank in charge of supervising all euro zone banks on Tuesday.
While ministers agree that creating a banking union is a sound idea, they cannot agree how best to structure it, how far to go in unifying banking systems to share risk and how to prevent discrimination between euro and non-euro countries.
With time running out to meet a pledge to complete the legal framework for banking union by the end of the year, Germany is sticking to its position that only big banks should come under European Central Bank scrutiny, while Britain wants the ECB's influence curbed so that it does not restrict London's power.
Spain's Economy Minister Luis De Guindos said the future of the euro depended on a deal.
"Banking union is crucial to remove all doubts about the future of monetary union," he told reporters as he arrived at the meeting.
Complicating the debate is Sweden, a non-euro zone country that has substantial banking interests in Finland, which uses the euro. Sweden is concerned that if the ECB is to have oversight of assets it owns, it must have some level of equal representation at the ECB.
Sweden's finance minister Anders Borg appeared to soften his stance on Tuesday, having last month threatened to block an agreement, but cautioned that ministers may have to meet again to clinch a deal.
"There can be no unfair treatment of the non-euro countries. There must be safeguards and we must be able to set our own... higher capital requirements for banks," Borg told reporters.
Diplomats also need to address the concerns of non-euro zone countries that aim to join the currency, such as Poland and Hungary, which also want to ensure they are not disadvantaged by the ECB taking a more powerful oversight of their banks.
France has found itself trying to bridge the differences and is pushing ministers to agree the first pillar of banking union - which involves making the ECB the supervisory authority - as soon as possible, in part to shore up its own banking system.
EU leaders hope that by setting up a single, powerful banking authority and later establishing a resolution fund for distressed banks, they will cut the link between indebted countries and their banking systems and start to right some of the wrongs that have exacerbated the debt crisis.
But Germany is concerned the project will develop into a scheme under which Berlin is left to foot the bill for banks too weak to survive on their own. And it is wary about directly recapitalising banks from the euro zone's rescue fund, which will be possible once banking union is up and running.
It wants the ECB's remit limited to bank big enough to pose a threat to financial stability, a restriction some diplomats said would undermine the scheme.
Austria's Finance Minister Maria Fekter said that compromise was also possible on this point.
"We will probably choose an approach with several tiers, so that the direction is set (by the new institution) and the... national authorities are used operationally in the controlling on the ground."
EU leaders agreed at a summit in October that they would have the framework for banking union agreed by year-end and the ECB would start to take over responsibility during the course of next year. But Germany is cautious about the pace.
CLOSE TO DEAL
If finance ministers can reach an agreement on Tuesday, it might allow them to finalise the framework by a summit of EU leaders on Dec. 13-14, as long as the European Parliament also plays its part and gives its approval. Hitting the deadline would send a strong signal, but it remains a long shot.
One of the trickiest obstacles is how to ensure that any supervisory system involving the ECB - an institution set up to manage euro zone issues alone - does not discriminate against non-euro zone countries such as Sweden and Denmark.
Hungary is another challenging case - about half of its lenders are owned by euro zone banks, meaning Budapest has a strong incentive to prevent the ECB taking decisions that could hurt its national financial system or sideline local lenders.
The ECB also has potential conflicts of its own to resolve. Its first responsibility is to monetary policy stability, but if it takes on the task of overseeing euro zone and possibly all EU banks as well, it must ensure there is no confusion or conflict of interest between the two mandates.
Another important reform, the introduction of stricter rules on banks' capital reserves in Europe, known as Basel III, is unlikely, however, to be finalised by ministers, delaying the new regime beyond a planned start on Jan. 1 next year.