UPDATE 1-Germany rebuffs EU call for more risk-sharing
* EU backs bank resolution scheme, defers funding issue
* Merkel rebuffs proposal for shock-absorber fund
* Berlin, Paris diverge on looser budget rules, ECB warns
By Noah Barkin and Paul Taylor
BRUSSELS, Dec 14 (Reuters) - Germany rebuffed calls for more financial risk-sharing in the euro zone on Friday, rejecting a proposal for a fund to help debt-laden countries cope with economic shocks and leaving open who would pay to wind down stricken banks.
With an eye on a general election next year, Chancellor Angela Merkel made EU officials drop any mention of a shock-absorber fund, backed by France and southern European states, from the conclusions of a two-day European Union summit.
She also resisted efforts by French President Francois Hollande and Italy to loosen EU budget discipline rules by exempting public investment when calculating national deficits.
The European Central Bank also rejected any let-out clauses from fiscal consolidation.
"Differentiating between good and bad deficits makes no sense," ECB executive board member Joerg Asmussen told Reuters. "Each deficit has to be refinanced on the capital markets. One should not touch the rules of the (EU) Stability Pact."
Amid optimism from many leaders that the euro zone has turned the corner by agreeing on a single banking supervisor and fresh support for Greece, Merkel warned that the bloc faced a long, hard slog to clean up public finances and revive growth.
"One reason I am careful with my forecasts is the adjustment process, the changes that we are going through are very difficult and painful," she said.
European Council President Herman Van Rompuy told a news conference that the issue of how to finance a Single Resolution Mechanism for banks until levies on financial institutions provided sufficient money would have be decided later.
However, European Commission President Jose Manuel Barroso said the bloc's ESM rescue fund would be able to inject capital directly into troubled banks in countries under an assistance programme, without it weighing on national debt, from mid-2013.
Greek Prime Minister Antonis Samaras said direct ESM recapitalisation for Greek banks could reduce Greek debt by 50 billion euros, but Germany and its north European allies have so far rejected any assumption of so-called "legacy assets".
After more than eight hours of late-night talks, leaders promised to push ahead with setting up a mechanism to resolve problem banks and launched talks on how to make countries stick to economic targets with the help of a small common fund.
Merkel made clear she had agreed only to a carrot-and-stick "solidarity fund" to reward states that carry out major economic reforms.
"We are talking about support linked to improvements in competitiveness." she told reporters. "We are talking about a very limited budget. Not three digit billions, rather 10 or 15 or 20 billion euros."
Hollande played down the setback to his hopes for a more ambitious fund, telling reporters: "Frankly, if we manage to pull together 10, 15, 20 billion euros quickly for the solidarity mechanism, I will take them ... and we'll see what happens afterwards."
With officials concerned about complacency creeping into decision-making now that financial markets have calmed and the crisis seems less acute, leaders appeared intent on showing that they are not relaxing.
But the combination of the German election next September and French reluctance to consider EU treaty changes before European Parliament elections in 2014 mean bolder steps in integration have been deferred until much later.
The sixth and last EU summit of 2012 had been intended to discuss how to overhaul economic and monetary union and correct the flaws that have fuelled three years of debt crisis.
The meeting was held just hours after EU finance ministers achieved a significant breakthrough by agreeing to make the European Central Bank the top supervisor of euro zone banks, the first stage in an eventual banking union.
That decision, and another by euro zone ministers to release up to 50 billion euros in new aid to Greece, marked two positive developments after a long year of crisis-management and eased pressure on leaders to make major strides.
The ECB said on Friday that even if financial stability strains had eased in the euro area since last summer, when ECB President Mario Draghi vowed to do whatever it took to preserve the euro, the situation remained very fragile.
"Key financial stability risks remain and there is no room for complacency," the ECB said in a report. The crisis could intensify again if governments fell behind on reforms, banks' health deteriorated and funding strains as money and debt markets are still not functioning properly.
A series of major hurdles remain. The next stages of banking union -- creating a resolution mechanism and coordinating deposit guarantees to protect savers -- may be fought over even harder. And then there will be political and financial obstacles to negotiate through 2013.
Much of southern Europe faces another year of grinding recession with record unemployment and deepening poverty that will tear at the fabric of wounded societies and may push governments' efforts to reduce deficits further off course.
Political risks include an Italian election due in February, a possible Spanish request for a full bailout, the German vote in September, and uncertainty over the recovery path of bailout recipients Greece, Ireland and Portugal.
Italy is a particular concern if the next government rows back on any of the economic reforms put in place by technocrat Prime Minister Mario Monti, whose time in office has helped stabilise financial markets and stave off the crisis.
Merkel praised Monti for helping bring about a rise in confidence in Italy. Monti declined to say whether he would bow to pressure from supporters at home and admirers abroad to stand in the election.