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* Issue of "legacy" banking problems vexes officials
* Burden may be split between states and ESM rescue fund
* Idea being circulated, formal talks have not yet started
* Compromise more likely if "legacy" assets reduced first
By Jan Strupczewski and Julien Toyer
BRUSSELS, Oct 19 (Reuters) - Euro zone officials are exploring ways to solve one of the thorniest issues they face: how to ensure distressed banking assets are dealt with at a national level while also breaking the link between indebted governments and their banks.
EU leaders agreed in June that the region's bailout fund, the ESM, should be allowed to directly recapitalise banks once a single euro zone supervisor is in place, probably during 2013. Such recapitalisations would, the leaders said at the time, break the "vicious circle between banks and sovereigns".
But last month Germany, the Netherlands and Finland reopened the June agreement, saying there needed to be a separation between "legacy" toxic debts -- those that have long weighed on banks in Spain and Ireland -- and future problems in the sector.
Direct recapitalisation from the ESM should only be possible for upheaval that occurs once the new supervisory authority is in place, the finance ministers of the three countries said.
German Chancellor Angela Merkel pressed that point at an EU summit on Friday.
"There will not be any back-dated direct recapitalisation. If recapitalisation is possible, it will only be possible for the future so I think that when the banking supervisor is in place we won't have any more problems with the Spanish banks, at least I hope not," she told a news conference.
Euro zone finance ministers are expected to have another crack at a meeting in Brussels on Nov. 12 at an issue that is critical to whether Spain's banking debts further weigh down the government's finances or whether that burden is lightened.
Three euro zone officials have told Reuters a compromise is being circulated among capitals and the European Union institutions, including the European Central Bank. It proposes to split the cost of recapitalising viable banks between the ESM and the governments -- essentially a halfway solution.
Formal talks on the issue have not yet started but if agreed the compromise could enable Spain and Ireland to shift some of the cost of propping up their banks off their balance sheets and onto the books of the ESM, which is underwritten and guaranteed by the 17 euro zone countries.
Such a move would be significant for two reasons: it would alleviate public finance problems in Madrid and Dublin and it would effectively represent the first financial transfers among euro zone member states.
Finland's Europe minister said on Thursday his country was willing to consider ideas for resolving the "legacy" issue, but only once a single banking supervisor was fully in place.
"Let's cross that bridge once we have a banking authority," Alex Stubb told Reuters.
"And once we have a banking authority, let's use our common sense, look at these issues case by case and see what kind of solutions can be found on the legacy assets," he said, hinting that separate agreements might be found for Madrid and Dublin.
The three officials Reuters spoke to said that even if in principle the ESM would not get involved in resolving "legacy" problems, exceptions could be made for Spain or Ireland.
"I think there is a third way, which is for the states to take part of the losses, to make them responsible," a French government official said. "We could consider that under some conditions still to be defined the ESM would be in a position to intervene on a past situation.
"Technical work still has to be done, the Spanish case shows this ... This needs a political and technical deal, so that will be discussed in the next weeks and months," the official said.
The euro zone is aiming for a definitive deal among finance ministers by the end of the year so that leaders can rubber stamp it early in 2013.
ECB President Mario Draghi said last week the central bank would take over supervising euro zone banks from the start of 2014, provided the legal framework is in place at the start of 2013, a schedule reiterated by EU leaders on Thursday.
That would give Spain and Ireland up to 14 months to work on reducing the "legacy" bad assets they have on their books, leaving a clearer idea of what the ESM may then have to take on.
"We may be saved by the length of the process," one senior euro zone policymaker involved in the discussions said. "By that time some of the banking issues in Spain will have been solved.
"You have Bankia, but also smaller regional banks, such as CatalunyaCaixa and NovaGalicia. By mid-2013 they will have been resolved, so they will not be there anymore."
He said that would allow everyone to respect the principle that states have to deal with past errors while at the same time allowing the ESM to take on its responsibilities for direct recapitalisation once that is possible.
"Even with that, you could then have some kind of tranching of risk to make sure the Spanish government and taxpayer continue to bear part of the losses," the official said, while the ESM would then take on what remains.