RPT-Franco-German divisions cloud efforts to fix broken banks
* Dealing with bust banks crucial step in banking union
* Euro zone ministers meet to discuss who pays for clean up
* France's Moscovici blames Germany for holding up project
By John O'Donnell and Robin Emmott
LUXEMBOURG, Oct 14 (Reuters) - The euro zone debated on Monday how to prop up banks likely to be declared unstable next year, but France's blunt criticism of Germany before the meeting laid bare the tensions surrounding the far-reaching financial reform.
Bank health checks by the European Central Bank are a critical step in establishing a single banking framework for the euro zone, giving credibility to ECB supervision and paving the way for the bloc to cooperate on saving bust banks.
But even before ministers from the 17-nation currency area met in Luxembourg, France's finance minister accused Germany of holding up progress on banking union to protect its own 'strange' financial system of regional banks that are "deeply intertwined ... with local political circles".
"What Germany fears ... is ... a loss of political control over its banks, which means in the final analysis a loss of sovereignty," Finance Minister Pierre Moscovici wrote in a book to be published this week called "Battles to resurrect France".
"It just goes to show that the champions of European integration and political union are not always those who appear to be. That's why banking union is being built so slowly and with such difficulty," he wrote.
There was no immediate reaction from Berlin as Germany's finance minister, Wolfgang Schaeuble, did not attend the first day of the two-day meeting because of talks to form a new German government.
The acrimony between the euro zone's two largest economies will complicate EU efforts to strike a deal by December on how to salvage failed banks, as set out by Europe's leaders.
Such a failure would put the ECB out on a limb when it begins supervision of euro zone banks late next year, without any means to shut or save banks in trouble.
Although nobody knows the true scale of potential losses at Europe's banks, the International Monetary Fund hinted at the enormity of the problem this month, saying that Spanish and Italian banks face 230 billion euros ($310 billion) of losses alone on credit to companies in the next two years.
The discord helps explain why five years after the United States demanded its big banks take on new capital to reassure investors, Europe is still struggling to impose order on its financial system, having given emergency aid to five countries.
During the region's debt turmoil, the European Union conducted two bank stress tests, considered flops for blunders such as giving a clean bill of health to Irish banks months before they pushed the country to the brink of bankruptcy.
The ECB's new checks are seen as the last chance to come clean for the euro zone as the bloc tries to set up banking union, a bold step in European integration.
"Our priority is to break the funding link between the sovereign and the balance sheets of banks," said Paschal Donohoe, Ireland's Europe minister, as he arrived for the meeting in Luxembourg. "A credible, robust banking union, delivered on time, is essential to doing this."
Late last week, European Central Bank President Mario Draghi underscored the need for publicly funded back-ups to recapitalise banks, saying those must be in place before its review of banks' health, expected early in 2014.
But Germany and Finland want individual states to pick up the costs of any clean-up rather than resort to the euro zone's rescue fund, the European Stability Mechanism.
"For now, we should rely on national backstops, meaning that if needed, national governments would step in," Finland's Finance Minister Jutta Urpilainen told reporters.
With the euro zone barely out of recession, a failure to put aside money to deal with the problems revealed could rattle fragile investor confidence and compound borrowing difficulties for companies, potentially killing off the meek recovery.
It raises the awkward question: who pays for the holes found in balance sheets in countries such as Spain and Italy?
This time around, the task of cleaning up banks should not be quite as daunting as five years ago because shareholders, bondholders and wealthy depositors can expect to take some of the losses, as happened in the bailout of Cyprus in March.
But if that is not enough, it will fall to governments to pick up the tab.
The debate opens amid ebbing political enthusiasm for banking union - originally planned as a three-stage process involving ECB bank supervision, alongside an agency to shut failing banks and a system of deposit guarantees.
In one sign of the divisions, Britain has repeatedly refused to sign off on the first pillar of the banking union framework, allowing the ECB monitor banks.
Having earlier agreed, London now wants additional assurances from ministers this week that Britain, which is outside the euro and polices its own banks, will not face interference from the ECB-led euro bloc.
Britain is likely to find a sympathetic ear in Berlin, which wants to keep London on side in its push to prevent stricter EU emissions rules to protect its luxury car makers.
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