* Banking union a major step towards deeper integration
* ECB would get powers to police banks under proposal
* Germany and Britain apprehensive about plan
By Claire Davenport
STRASBOURG, France, Sept 12 (Reuters) - Europe will move a step closer to a "banking union" on Wednesday with plans for the European Central Bank to oversee banks as part of efforts to end years of financial and economic turmoil in the region.
European Commission President Jose Manuel Barroso will outline the proposal in his annual "state of the union" address, which will also set out a path towards deeper economic integration across the euro zone and the wider EU.
The proposed banking reforms, which Barroso will present to the European Parliament, need to be approved by EU member states. They aim to break the link between heavily indebted countries and their struggling banks, tackling a core element of the debt crisis that has afflicted Europe since early 2010.
Spain, which is trying to cut its budget deficit in the middle of a recession, has already had to request up to 100 billion euros in European aid to rescue it most troubled banks.
For the plan to work, it will require countries to surrender a degree of sovereignty over supervising their banks. This has long been a national responsibility and the proposal has already led to tensions with Germany and Britain.
A banking union foresees three steps: the ECB gets the power to monitor all euro zone banks and others in the wider EU that agree to the oversight; the establishment of a fund to close troubled banks; and a fully fledged scheme to protect citizens' deposits across the euro zone.
Establishing a common framework for dealing with problem banks would mark a departure from the previously haphazard approach taken by the euro zone's 17 members that has frustrated investors and helped drive up borrowing costs for weaker states.
"The challenge is gigantic," said Nicolas Veron, an expert in EU financial policy with think-tank Bruegel. "It's not just banking union. Banking reform is part of a broader agenda of integration that has been made more pressing by the crisis."
Handing powers of supervision to the ECB also unlocks the possibility of direct aid to banks from the euro zone's permanent rescue scheme, the European Stability Mechanism (ESM), although it is not clear when Spain and others would benefit.
Under the terms of the proposal, the ECB would be put at the head of the current fragmented system of national regulators with the power to police, penalise and even close banks across the euro zone.
The ECB would also gain powers to monitor banks' liquidity closely and require them to keep more capital to protect themselves against future losses.
Reaching agreement on the terms of the union could be complicated, delaying the introduction of the new regime beyond the target set by euro zone leaders of the beginning of next year.
Germany, the euro zone's economic heavyweight, is opposed to allowing the ECB supervise all euro zone lenders.
Berlin says the central bank will be overstretched if it has to monitor all 6,000 euro zone banks. Commission officials argue that even small banks can cause a wider crisis, as happened at Britain's Northern Rock.
Outside the euro zone, Britain is also concerned. Although it will not join the scheme, many international banks in London have operations in the euro zone which will be affected by the ECB's new supervisory reach.
London is also worried that the ECB, emboldened by its new powers, will demand regulation that could undermine the city's position as the European financial capital. Similar concerns are shared by countries such as Sweden.
A draft document lays down a phasing in of this supervision over one year and says the ECB should be able to police all banks. The ECB should begin monitoring half of the euro zone banking sector from the middle of next year.
International banks are also apprehensive. The Association for Financial Markets in Europe, which represents banks including Deutsche Bank and HSBC, warned against "driving a wedge" between those countries inside the banking union and those that stay out.
"If there were to be a hint of restrictions on conducting euro transactions in London, for example, that would be a concern," Andrew Gowers, a spokesman for AFME said. "Banks do not want to be told where they can or cannot conduct business."