BRUSSELS (Reuters) - European Union finance ministers will try to finalize plans to put the European Central Bank in charge of supervising all euro zone banks on Tuesday, but divisions over how ECB oversight will work threaten to undermine one of Europe's boldest reforms.
While leaders are agreed that creating a banking union is a sound idea, they cannot agree on how best to structure it, how far to go in unifying banking systems to share risk and how to prevent discrimination between euro- and non-euro countries.
With time running out to meet a pledge of completing the legal framework for banking union by the end of the year, Germany is sticking to its position that only big banks should come under the ECB's scrutiny, while Britain wants the ECB's influence curbed so that it does not restrict London's power.
Further complicating the debate is Sweden, a non-euro zone country that owns most of the banks in Finland, which uses the euro. Sweden is concerned that if the ECB is to have oversight of assets it owns, it must have some level of equal representation at the ECB.
And then there are non-euro zone countries that aim to join the currency in the years ahead, such as Poland and Hungary, which also want to make sure that they are not disadvantaged by the ECB taking a more powerful oversight of their banks.
France finds itself trying to bridge the differences and is pushing ministers to agree the first pillar of banking union - which involves making the ECB the supervisory authority - as soon as possible, in part to shore up its own banking system.
EU leaders hope that by setting up a single, powerful banking authority and later establishing a resolution fund for distressed banks, they will cut the link between indebted countries and their banking systems and start to right some of the wrongs that have exacerbated the debt crisis.
"Banking union is one of our priorities," French Finance Minister Pierre Moscovici told the European Parliament during a hearing on Monday. "We must break the link between the financial crisis and the sovereign crisis. We are working on finishing this by the end of the year."
Germany, on the other hand, is concerned the project will morph into a scheme under which Berlin is left to foot the bill for banks too weak to survive on their own. And it is wary about directly recapitalizing banks from the euro zone's rescue fund, which will be possible once banking union is up and running.
EU leaders agreed at a summit in October that they would have the framework of banking union agreed by year-end and the ECB would start to take over responsibility during the course of the year. But Germany is cautious on the pace.
Finance Minister Wolfgang Schaeuble said on Tuesday he could not be sure the legalities would be agreed by the end of the year and was doubtful whether troubled banks would be able to tap the euro zone rescue fund for help anytime soon.
"It's not as if you are looking at snow melting," Schaeuble said. "It is not going to go that quickly."
If finance ministers can reach an agreement on Tuesday, it might allow them to finalize the framework by a summit of EU leaders on December 13-14, as long as the European Parliament also plays its part and gives its approval. Hitting the deadline would send a strong signal, but it remains a long-shot.
"We are close to a deal," said one EU diplomat close to the talks. "The remaining obstacles are political - it's about what Germany wants and what Britain wants."
One of the trickiest obstacles is how to ensure that any supervisory system involving the ECB - an institution set up to manage euro zone issues alone - does not discriminate against non-euro zone countries such as Sweden and Denmark.
Hungary is another challenging case -- around half of its lenders are owned by euro zone banks, meaning Budapest has a strong incentive to prevent the ECB taking decisions that could hurt its national financial system or sideline local lenders.
The ECB also has potential conflicts of its own to resolve. Its first responsibility is to monetary policy stability, but if it takes on the task of overseeing euro zone and possibly all EU banks as well, it must ensure there is no confusion or conflict of interest between the two mandates.
Another important reform, the introduction of stricter rules on banks' capital reserves in Europe, known as Basel III, is unlikely, however, to be finalized by ministers, delaying the new regime beyond a planned start on January 1 next year.
Additional reporting by Annika Breidthardt; Editing by Dan Grebler