* Commission fears regulators are fragmenting EU markets
* Regulators have a month to prove lack of discrimination
By Huw Jones
LONDON, Feb 4 (Reuters) - National regulators across the European Union have until the end of the month to show they are not damaging the single market by being too heavy handed with banks from elsewhere in the bloc, the EU's executive European Commission said on Monday.
It reminded them in a letter last Friday that the free movement of capital is a founding tenet of the single market.
On Monday, the executive said in a statement that on several occasions national supervisors have acted independently to impose "allegedly disproportionate prudential measures" on local arms of non-domestic EU banks.
"In taking such action, national supervisors did not respect the mandatory procedures, such as consulting other national supervisors of the same banking group in advance," it said.
The supervisors must inform the commission by the end of February about their "current supervisory practices" so that it can "determine any possible further steps as appropriate".
The executive, as guardian of the EU treaty, can take a country to the European Court of Justice for rule breaches that could trigger penalties such as fines.
The European Banking Authority would try to resolve differences among supervisors before any legal action would be considered, EU officials said.
Last month the executive said it was looking at whether German bank regulator BaFin was inhibiting the free movement of capital by imposing curbs on moving cash within a bank.
The Bank of Italy is said to have raised the issue about BaFin with the European Banking Authority. Italian bank UniCredit has a large German subsidiary, HVB.
The European Central Bank becomes the main regulator for big euro zone lenders from next year and this will help to iron out supervisory clashes within the euro zone, officials said.
The Commission said curbs have been on shifting capital and profits within groups, and on lending. All supervisors must work together to avoid fragmenting the single market and harming growth and stability, it said.
"It's becoming a problem," said one regulatory source on condition of anonymity.
For example, as a safeguard, supervisors are "encouraging" banks to use the ECB's payment system for loans to other euro zone lenders rather than lending directly.
Debate among supervisors has become "very active" in order to push against fragmentation, the source said.
The EU is approving a law to implement Basel III accord that sets global minimum standards for capital requirements.
But the EU wants to limit leeway for national regulators to impose higher requirements on banks under exceptional circumstances when financial stability is at stake.
Britain has lobbied for more wriggle room as its regulators discourage foreign branches and puts pressure on lenders to set up subsidiaries that are required to have their own capital and liquidity buffers to withstand market shocks.
Britain has put pressure on bank branches from Cyprus, an EU member country, to become subsidiaries.
The U.S. Federal Reserve proposed in December that arms of foreign banks face the same rules as local banks.
This so-called "subsidiarisation", dubbed balkanisation by critics, is largely due to not being able to wind down a failing big bank without taxpayer help or triggering the market mayhem seen when Lehman Brothers went bust in 2008.
Taxpayers remain on the hook until the "too big to fail" problem is solved, which could take years and, in the meantime, supervisors want to play safe and make sure all banks on their patch hold enough liquidity and capital.