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BRUSSELS (Reuters) - EU finance ministers will seek on Tuesday to break an impasse over a new regime to supervise banks, but with much of the plan contested and time running short to agree, the European Union risks seeing this centerpiece reform unravel.
So far, countries in the euro zone have attempted to contain the financial crisis with piecemeal measures. The banking union is the first concerted attempt to integrate the bloc's response to problem lenders to win back confidence.
Finance ministers from the bloc's 27 countries will attempt to advance talks on divisive questions such as the scope of the European Central Bank's powers and breadth of the scheme that would be a first step in a banking union.
"The issues are highly technical, politically charged and running up against deadlines, but we must seek to reach compromises to chart a path out of the crisis," said a senior EU diplomat involved in the talks.
Some officials are worried that the banking union construct is already crumbling in the face of powerful opposition both within and outside the euro.
Germany, the leading economy in the euro zone, wants the ECB's oversight curtailed to top banks while Britain, the biggest country outside the euro, wants to stop the central bank from taking decisions that infringe on its interests.
The prospect that the scheme will be watered down threatens to undermine confidence in the euro and its flagging economies, recently lifted by a pledge from the ECB to support stricken countries with bond-buying if certain conditions are met.
"Britain's concern is legitimate," said the EU diplomat. "But the problem is how to give the United Kingdom a voice when it also wants to be able to block any rules it doesn't like. That's a political problem."
Making the ECB the supervisor for lenders chiefly in the 17 countries that use the euro would be the first of three pillars in a banking union and one EU leaders have committed to complete by this year.
This would allow the euro zone's rescue fund, the European Stability Mechanism, to help troubled lenders directly rather than via their governments, breaking with the previous ad hoc approach where smaller states such as Ireland were left to solve their banks' problems alone.
Complementing this new regime of supervision with two additional pillars -- a central scheme to wind down banks and a combined means of deposit protection to prevent bank runs -- would complete the banking union, underpinning lenders and the euro currency.
Spain, which is hoping to share the cost of its bank bailout with stronger euro zone countries, underscored the significance of a banking union on Monday.
"For Spain, the economic recovery is difficult, near impossible until the doubts surrounding the euro are resolved ... so the Spanish government is convinced that banking union is fundamental," Spain's Economy Minister Luis De Guindos told members of the European Parliament in Brussels.
But some officials in Brussels are growing increasingly alarmed by British and German opposition.
"We don't want a banking supervisor that doesn't have any teeth," said one official. "It should not be a coordinating body. The final decision must be made by the ECB and that goes for small banks as well as systemic ones."
Britain has proposed a means for countries outside the banking union to stop the ECB taking decisions that could affect their interests. Since Britain would dominate this group, many countries see this as London effectively demanding a veto and oppose it.
Germany, which wants to keep primary oversight of the country's community savings banks, is pushing to limit the ECB's remit to systemically important banks.
It is also worried that the more banks are included in the scheme, the higher the potential cost when, as is ultimately planned, supervision is backed up by a central fund to pay for the closure of troubled lenders. Germany, Europe's largest economy, would have to foot a large part of any such bill.
The EU ministers will also discuss new rules governing the amount of capital banks must set aside to cover unpaid loans and other risks as well as a proposal, backed by Germany but opposed by Britain, to cap bankers' bonuses at three times their salary.
Editing by Mike Peacock