* Key first step in creation of European banking union
* Hardest talks on sharing cost of failing banks yet to come
* Paves the way for bailout fund to eventually prop up banks
By Carmel Crimmins
DUBLIN, Dec 13 Europe is still some way from severing the vicious link between troubled banks and states despite a landmark deal anointing the European Central Bank as supervisor-in-chief.
Persuading national governments to cede responsibility for their biggest lenders to Frankfurt was a major first step towards banking union but it was arguably the easiest bit.
Getting agreement on sharing the burden when one of those banks goes belly-up, the key component of a euro zone firewall, could take years yet to be agreed, with German elections late next year likely to rule out any meaningful discussion of bold policy moves beforehand.
"The deal on ECB supervision is step one of 10 or 20 to get banking union delivered and there are going to be lots more summits," said Alex White of JP Morgan.
"We will only really feel happy about the region's future when we have got ... some sort of banking union system that enables a stressed Spanish or Italian bank to be dealt with on a regional level. This is a step towards that but from the signs the Germans are giving we are good 18 months away from that."
Europe's financial crisis showed how toxic banks or overstretched governments in one part of the bloc could put the whole region in peril.
A banking union is meant to break what leaders described in June as the "vicious circle" whereby indebted governments prop up their ailing banks at great cost and the banks in turn buy the lion's share of their country's bonds as they sink in value.
To succeed it must also reassure investors and savers that if they put their money into a euro zone bank, the bloc will, up to a point, honour them.
Making the ECB the euro zone's ultimate banking supervisor after six months of negotiation -- a short period of time in EU terms -- now paves the way for discussions on how to deal with bank failures.
Market reaction to the deal was muted but investors said further progress would boost shares and bonds.
"If we can clean up the banks, it adds another brick in the firewall around the euro. And we will start to see some increased confidence among investors to invest," said Morten Spenner, CEO of International Asset Management.
"Is there still event risk out there? Yes, without any doubt, but it has reduced I think. We are not faced with the same scale of risk of a bank collapse as we were before."
At a summit in June, EU leaders pledged that once a common bank supervisor was in place, the bloc's 500 billion euro bailout fund, known by its acronym the ESM, would have the power to directly recapitalise struggling banks, removing the burden from governments already saddled with high public debt.
But Germany, the bloc's paymaster, discouraged any discussion on when the ESM would be able to directly support ailing banks. It will not happen before 2014.
SIZE ISN'T EVERYTHING
Under the deal, the ECB will directly supervise banks with assets of at least 30 billion euros or larger than one-fifth of their country's economic output, meaning at least 150 banks across 17 countries.
National supervisors will oversee smaller lenders but the ECB has the authority to step in to deal with smaller banks if problems arise.
Using size to decide which banks to supervise is a simple but blunt tool.
The Bank for International Settlements (BIS) used five categories, including interconnectedness, when deciding what banks were systemically important in the aftermath of the global financial crisis.
A spokesman for the European Commission said once a bank exceeded the 30 billion euros threshold, it would fall under the ECB's supervision, and if it dropped below 30 billion, it would no longer be directly monitored from Frankfurt.
SMALL BUT DANGEROUS
Restricting the size of the lenders affected means that most of Germany's politically influential savings and cooperative banks, will remain under local supervision, satisfying a key demand from Berlin.
It also means that most of the bloc's 6,000 or so lenders will remain outside the ECB's direct oversight and most critically of all, as things stand, they will remain dependent on their national governments if things go wrong.
Collectively, small banks can be dangerous.
"This is worrying that they have allowed small banks out of this," said Alan Ahearne, who served as special adviser to the Irish government during the peak of its banking crisis.
"A failure of small banks, lots of them, if there is some common shock, that can do a lot of damage to the sovereign."
Spain's Bankia, which was at the heart of Madrid's banking crisis, was formed from a merger of seven struggling regional lenders in 2010.
The new system of supervision should be up and running by March 1, 2014 although ministers agreed that could be delayed if the ECB needed longer to prepare itself.
Finding personnel and organising the welter of data on its 150 plus charges, many of which have operations spread across the globe, will be an enormous task. The ECB will also be competing with the banks for talented regulatory experts.
"There aren't, as far as I know, tens of thousands of unemployed bank regulators wandering around looking for a job," said White. "It will take time to build the system."