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* Reservations of Germany, others on ECB role in supervision
* Four countries want to bolster national watchdogs
* Timing of scheme in doubt, legal concerns flagged
By John O'Donnell
BRUSSELS, Nov 7 (Reuters) - A group of AAA-rated euro zone states, led by Germany, wants limits on the ECB's remit in a proposed banking union, possibly undermining a scheme to restore the currency zone's stability.
According to a document circulated by Germany, Finland, the Netherlands and Luxembourg, and seen by Reuters, the four core euro zone countries advocate stronger powers for local regulators when it comes to day-to-day oversight of banks in the banking union scheme.
They worry the banking union as proposed could see their role eclipsed by that of the European Central Bank.
EU leaders meet in December to formally vote on making the Frankfurt-based central bank the core of a euro zone banking union but the document obtained by Reuters casts doubt on whether the plan will go ahead from next year.
The four countries spell out the options for deciding when national watchdogs rather than the ECB should take the lead in supervising banks.
"The text suggests bringing back more control to the member states," said one EU official. "The ECB will have the final say, but the question is whether it is exercised directly by the ECB or on behalf of the ECB by national authorities."
The reform is part of efforts to bolster the euro currency. Establishing a new mechanism to supervise banks will pave the way for the euro zone's rescue fund, the European Stability Mechanism, to directly assist banks rather than having to do so through the governments of their home countries.
The document highlighted another obstacle, namely the concerns of Germany and Finland that there is insufficient legal separation between the ECB's role in deciding monetary policy and supervising banks.
One official said there were also concerns that the more banks included in the scheme, the higher the potential cost if, as is ultimately planned, the banking union is backed up by a central fund to pay for the closure of troubled banks.
They also suggest strengthening the role of a supervisory board within the ECB, a body that would play a role in supervising lenders and where non-euro zone members would have a vote.
"One of the main points is the full delegation of powers to the supervisory board," said a second official. "They want the board to take final decisions, rather than just prepare decisions."
"Germany and Finland are not convinced that the necessary separation of decision-making can be achieved without recourse to another legal basis," officials write in the document.
The paper, which is based on earlier drafts of legislation for the supervision scheme, also deleted references to the latest starting date of Jan. 1, 2014 for the supervisory mechanism, a signal that with so many issues unresolved striking a deal may take longer than planned.
It also revised an earlier draft which some had interpreted as meaning that the ECB's supervision would be limited to banks that accounted for half of their country's banking assets. The quartet says different criteria, including a bank's systemic risk, exposure and cross-border activity, could be taken into account.
The banking union would have three steps: the ECB takes over monitoring euro zone banks and others that sign up; a single fund is created to close down and settle the debts of failed banks and finally a scheme to protect savers' deposits is established.
The close ties between some troubled governments and the banks they supervise, and on which they also rely to buy their debt, have dragged both ever deeper into crisis.
A banking union, if completed, would break this link by making the policing of banks supranational and establishing central schemes paid into collectively to cover the costs of closing failed lenders and shielding savers. (Additional reporting by Claire Davenport; Editing by Ruth Pitchford)