UPDATE 1-Europe treads softly in challenging big banks' power
* EU Commission blueprint to propose hiving off trading
* New rules from Brussels to come years after U.S.
* Bank sector still larger than before the crisis
BRUSSELS/LONDON, Jan 27 (Reuters) - Europe will consider how to challenge the dominance of its big banks this week, but any new rules to isolate risky trading will take years to begin and there will be no attempt to split off market betting from deposit taking.
In a blueprint expected on Wednesday, the European Commission will outline how trading by banks can be walled off from customers' cash, but the debate among countries, many of whom are sceptical of the need to change, starts only in 2015.
After the collapse of Wall Street's Lehman Brothers in 2008, world leaders pledged to tackle banks that were "too big to fail" to shield taxpayers.
Yet in the more than six years of crisis that toppled banks in Europe and sucked in countries from Greece to Spain, little progress has been made, and the size of banks such as Germany's Deutsche Bank or France's BNP Paribas remains Europe's Achilles heel in the event of another crash.
Their vast scale is also blamed for fuelling risky trading and growth in the multi-trillion dollar derivatives market.
The proposed new rules, which are still many years off, signal that European policymakers have largely backed down in the face of banking resistance.
On Wednesday, the European Commission is set to outline its proposals for a new law, including a ban on trading by banks using their own funds and separating other types of trading from the 'safe' side of banking - taking deposits.
If agreement is reached, which is also in doubt, the rules would only take effect in 2017, some two years after similar action in the United States.
The difficult nature of negotiations ahead with EU member countries was highlighted by French Finance Minister Pierre Moscovici, who said that banks' "speculative" activities should be ring-fenced rather than banned.
BUCKLE UNDER PRESSURE
The fact that it has taken so long even to broach the issue signals that, except in crisis, the political will is lacking.
"The pressure has been so high from the banks that the Commission's proposal will be very limited. It won't change anything," said Monique Goyens, director general of consumer group Beuc, who was a member of an advisory group on the issue led by Finnish central bank governor Erkki Liikanen.
"The 'too big to fail' that we wanted to address is not going to be addressed if this does not have more teeth."
Liikanen recommended mandatory separation of banks' "proprietary" trading with their own funds and other market betting into a separate legal entity. It would have its own capital to cushion risks but would remain within the bank.
On this count, the EU draft law is set to go further, and, like the Volcker Rule in the United States, ban banks from engaging in such trading, which has shrivelled in any case.
The U.S. rule, however, applies to all banks, while in the EU it will only apply to lenders above a certain size, taking in the top 30 or so banks.
In the EU draft, other types of trading, such as derivatives, should be put in a separate division, as Liikanen suggested. The United States has a similar set-up, known as the "push out rule", forcing some commodity, derivatives and equity trades to be walled off.
Crucially, however, the EU law stops short of physically breaking up big banks into retail and wholesale units, a step critics say is needed to remove the too-big-to-fail threat.
Germany and France, which are determined to shield their flagship lenders from any such shake-up, have repeatedly attacked the plans, privately warning Brussels last week not to overstep the mark.
Deutsche Bank, one of Europe's largest banks, has total assets of more than 1.6 trillion euros - two thirds the size of Germany's economy - and lends to the country's top companies.
France has resisted interference in the structure of its big banks, including BNP Paribas and Credit Agricole. Paris sees these "national champions" as critical in financing their economy as well as a bulwark against foreign investors making inroads into its financial system.
France and Germany want the European Commission to soften the separation rules for non-proprietary trading to avoid crimping the flow of credit. They also do not want to ban proprietary trading.
Britain will also oppose any law from Brussels that would crimp its ability to decide how to deal with its biggest banks. It wants the retail arms of banks to hold more capital, with some risky trading kept within the wholesale arm.
The result is a patchwork of different reforms globally.
In Europe, with elections to the European Parliament in May and a changeover of the EU Commission's top officials later in the year, nothing will happen for now.
"This proposal serves only as food for discussion and will have to be presented to the newly elected European Parliament," said one EU official.
Germany and France's line of argument closely follows that of industry, which claims that regulatory interference could damage their ability to lend to the economy. But Thierry Philipponnat, a former investment banker who leads Finance Watch, which campaigns for tighter regulation, challenged this.
"European banks lent only 28 percent of their balance sheets to households and corporations, with the remaining going into financial markets and, in particular, derivatives," he said, pointing to an 80 percent surge in the size of the banking system during the decade to 2011.
"The paradox is that if you are big, you get implicit state support because you are too big to fail. And so you grow even bigger with risky activity that makes the entire system more fragile."
Even banking lobbyists privately concede that big banks pose a risk. "We've done the equivalent of closing a few coal-powered power stations but created a number of nuclear reactors," said one. "If they go belly up, God help us."
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