* EU paper urges strict curbs on power of agency to close banks
* Lawyers pinpoint pitfalls in advancing to banking union
* EU Commission says blueprint sound, Germany softens stance
By Huw Jones and John O'Donnell
LONDON/BRUSSELS, Oct 8 (Reuters) - European Union lawyers have raised concerns about proposals for banking union, warning that plans aimed at drawing a line under years of financial crisis could fall foul of EU law.
In an opinion issued this week and seen by Reuters, the legal service of the European Council said EU law would only allow limited powers to be given to an agency to close or salvage troubled banks, potentially undermining a central element of the scheme.
The 26-page ruling is a blow to efforts to establish a framework to jointly deal with stressed lenders across the eurozone and break the link between indebted countries and their banks.
Setting up such a system raises an array of political and legal complications, including who should decide when an ailing bank must be closed and who pays the bill, an issue of particular concern to Germany, the euro zone's largest economy.
In their second piece of legal advice to member states, dated October 7 and prepared for EU ministers, the lawyers warn of the pitfalls of giving a new agency or board too many powers to close troubled banks.
In particular, it underlines the need to limit the "margin of discretion" or extent of any powers given to a body that will decide about the closure or 'resolution' of a bank in a euro zone state. It questions the right, for example, to use a European fund for tackling problem banks.
The advice lends support to the idea of giving responsibility to the European Commission or another EU institution rather than an external agency, since otherwise the arrangement may not be compatible with the EU's treaty or basic law.
That view is likely to rankle Germany and others who are worried about the Commission being granted too much authority. The proposal to give the Commission and a related board the power to close banks was made by the Commission and now needs backing of member states to become law.
"The Legal Service considers that the powers ... need to be further detailed in order to exclude that a wide margin of discretion is entrusted to the board," officials write in the document.
But a spokeswoman for the European Commission said that while its blueprint could be changed to bring it into line with the advice of the lawyers, the EU executive believed the overall proposal was legally sound.
By highlighting some of the limits of existing EU law, however, the lawyers give weight to the argument championed by Germany that a potentially long-winded reworking of the EU's treaty may be needed to underpin the new structure.
Such a step would, however, be politically hazardous and may invite many of the bloc's 28 member countries to try to renegotiate its terms. Britain's Prime Minister David Cameron could use it to further distance the country from Brussels.
"Legal obstacles could be dealt with by an EU treaty change but there are two obstacles - David Cameron and the European Parliament, which would ask for a full fledged convention," said Daniel Gros of the Centre for European Policy Studies.
"Without this, however, you are going to end up with something so contorted that it doesn't make much sense."
Germany, which had originally called for changes to EU law to underpin banking union, appears now to be taking a more pragmatic approach, starting to build banking union even if some legal questions about its completion remain unanswered.
"In a number of questions we are coming to alternative solutions which don't require constitutional changes," Wolfgang Schaeuble, Germany's finance minister, said on Tuesday, suggesting, however, that changes to EU law would be needed in the long term.
"One could use the resolution mechanism in the first step ... not for all banks, but rather just systemically-relevant banks," he said.
The advice comes shortly after EU lawyers warned that the new system must respect a country's autonomy when deciding on spending. This reflects fears that governments would be left with the clean-up bill if an EU agency were to order the closure of a bank.
The legal concerns, prepared by officials at the European Council, which hosts EU ministers' meetings, add to the complexity of an issue that is already politically difficult.
Political impetus has already slowed with the return of market calm. Germany is also opposed to any hasty agreement that would leave it indirectly on the hook for helping weaker countries address the problems of their banks.
Unlike in the United States, where rapid infusions of capital put its banks quickly back on track, Europe is still trying to repair a financial system damage by crises.
By establishing a banking union, it hopes to win back investor confidence. The first step towards creating this union will happen late next year, when the European Central Bank takes on supervision of banks throughout the euro zone.
The second pillar of the project is creation of an agency to close troubled banks and a central fund to help pay for the costs of the clean-up.
But EU states are divided as to how much of this task should be taken on by a central resolution board and how much should be done by the European Commission.
The legal opinion, which adds further fuel for this debate, looks at decisions by the bloc's top court, the European Court of Justice, in particular the "Meroni" case of the late 1950s.
This set parameters on the "balance of powers" between EU institutions such as the European Commission and how much discretion new agencies could have.