LONDON (Reuters) - This time last year the European Banking Authority was fighting a losing battle with Germany's financial regulator, just seven months after it started work as the EU's new supranational watchdog charged with overcoming national differences to tackle the bloc's banking crisis.
A year later and the EBA's very survival is in question as the euro zone's leaders debate whether nothing short of a banking union will break the death spiral that links the weak euro debtor nations with the banks whose debt they hold.
At the heart of the debate lies the issue of how far will national governments, whose supervisors sit on the EBA, give up regulatory sovereignty to centralized EU decision making.
Momentum is building behind the European banking union plan and the bloc's leaders will try to move it along at their summit on Thursday and Friday, with talk of some building blocks being in place in 2013.
"That would be ambitious but it would be doable in the context we are in," said David Wright, secretary general of the global securities watchdog IOSCO and former deputy chief of the European Commission's financial services unit.
A union would need a single banking regulator. But the EBA, made up of supervisors and central bankers from all 27 EU states, has shown in its short life that it lacks the power to be effective in that role without changes.
In June last year Helaba, one of Germany's biggest lenders, was about to fail the EBA's new "stress test" designed to test the capital strengths of individual banks across the European Union.
German regulator Bafin came out fighting, and accused the EBA of overstepping the mark and cobbling together new rules on capital. The Bundesbank weighed in too, saying the stress test was just a "show" for investors and Bafin allowed Helaba to pull out of the test two days before results were published.
Losing the backing of Europe's strongest country showed the difficulties the EBA has faced and now the European Central Bank (ECB) is being promoted by Germany and France as the possible main regulator for banks in the 17-country euro zone, if not the wider EU.
But the European Commission is lobbying to get a separate body for the role, such as a beefed up EBA.
"We need both the EBA and the ECB," said Sharon Bowles, the UK Liberal Democrat chair of the European Parliament's economic affairs committee, which has joint say with member countries on EU financial regulation.
The ECB could provide a clear link between supervision and monetary policy, while the EBA could focus on rulemaking in the wider single market, she said.
But Bowles, along with others, said even a beefed up EBA or a new agency could not avoid having to compromise in the face of vested national interests as it would always be an extension of the European Commission serving member nations and not fully independent like the ECB.
The first steps to forging a banking union would be to integrate supervision, consolidate the power to intervene in banks to safeguard investors and create a single Europe-wide deposit guarantee.
The ECB is seen as having a head start in the race to become the main banking regulator since it has the firepower to step in as a lender of last resort. It has already lent 1 trillion euros in cheap three-year loans to help banks through a funding drought.
One senior EU regulator also said there was a need for a single body that can offer funds and at the same time demand restructuring.
"If you are the lender of last resort you want to know what sort of capital the banks are holding," another supervisor closely involved in European regulation said.
Or as German Chancellor Angela Merkel has put it, 'liability and control belong together'.
"The ECB would have much more clout to conduct a stress test or tell banks what to do by saying it won't give them any more liquidity," said Karel Lannoo, chief executive of the Centre for European Policy Studies, a Brussels think tank.
The ECB would be turned into Europe's equivalent of the powerful Federal Reserve, in charge of monetary policy, banking supervision and payments systems, Lannoo said.
That would leave the EBA with a narrower focus on routine supervisory tasks and updating technical standards.
This sharing of roles would not be new and is known as a "twin peaks" system such as the one being introduced in Britain where the Bank of England will become the main regulator from next year while a junior body will supervise the conduct of the nation's banks.
But moving to twin peaks won't be without a fight, with opponents not just defending vested interests but also warning of potential conflicts of interest, noting that no supervisory model proved infallible in spotting the financial crisis.
Would one side of the ECB be in a hurry to raise interest rates if it felt already fragile banks could suffer even more, critics ask.
"The combination of a European monetary authority with a supervisory authority is a dangerous one," said a senior central bank source. "I would be in favor of developing the EBA into a true European supervisor."
As it stands now the EBA is still in its infancy and operates with a budget of 20.7 million euros and 94 staff, tiny compared with national regulators like the UK's Financial Services Authority.
It was seen as a radical step forward in EU integration following the 2007-09 banking crisis by ushering in majority voting to replace the Committee of European Banking Supervisors (CEBS), which took decisions by consensus.
But the sheer size of Europe's banks -- with combined assets of 34 trillion euros the banking sector here is three times bigger than in the United States -- means that their problems can overwhelm host countries, as Spain and Ireland can testify, and European leaders now want a stronger watchdog.
Whether the ECB or a beefed up EBA, it would need more power to stand up to member governments, who in the original stress test refused to entertain the idea that banks' sovereign debt holdings might be at risk, arguing that a member state could not default.
Fast forward a year and Cyprus has just become the fifth euro zone country after Greece, Portugal, Ireland and Spain to ask for a bailout.
This week's EU summit will debate if this tougher watchdog should serve just the euro zone's 17 members or all 27 members of the EU.
But ultimately the EBA's future will be determined by how far and how fast politicians can push ahead with moves to get a banking, or even fiscal union in the euro zone.
"The key ... is whether European governments indicate that they are willing and able to do together for the euro area banking system as a whole what they all did individually in 2008/09 for their own banking system," said Huw van Steenis, analyst at Morgan Stanley.
"The current set of EU banking union proposals, whilst directionally helpful, are too long-term or too timid to address the crisis," he said.
Additional reporting by Douwe Miedema in London and Alexander Huebner and Jonathan Gould in Frankfurt; Editing by Greg Mahlich