October 18, 2012

European leaders meet for a two-day summit on Thursday where they will try to bridge divisions over a banking union intended to underpin the euro zone. But questions over the scheme's scope and mechanisms are likely to take months to resolve.

The European Commission has proposed making the European Central Bank responsible for supervising lenders as a step towards a union where chiefly euro zone countries would jointly tackle problem banks and shield savers' deposits.

Cross-border supervision should allow the euro zone rescue fund, the European Stability Mechanism (ESM), to inject capital directly into struggling lenders although it is unclear when and to what extent countries like Spain and Ireland can benefit.

There are many hurdles to a banking union, each with the potential to delay or derail the plan.

* The banking union is designed mainly for the 17 countries in the euro zone. But it requires approval from all 27 countries in the European Union. The Prime Minister of the Czech Republic - which is not in the currency area - said on Wednesday that he was worried about issues including a deposit insurance scheme, and that he might use this veto.

* The European Commission has proposed that the ECB should over time take charge of the roughly 6,000 euro zone banks.

Germany, which is keen to retain primary oversight for its regional savings and cooperative banks, is reluctant to grant such wide scope. If it succeeds in keeping supervision of some of its banks, officials fear that other countries could demand the same right.

* Countries that do not use the euro will be free to join the banking union but they would face the difficulty that they may not be allowed participate in supervisory decisions taken by the ECB, the euro zone's central bank.

One option would be to create a new body that includes non-euro states. Even so, many countries are apprehensive because they fear this could put them on the hook financially to solve banking problems in Greece, for example.

* Britain, home to Europe's biggest financial centre, has said it will not take part in the banking union. It is also seeking safeguards that critics say amount to a right to veto decisions by the ECB.

London intends to propose giving countries outside the banking union the possibility of blocking those within the project from clubbing together to shape EU-wide regulations, officials have told Reuters.

Protracted negotiations would delay agreement on the new framework beyond the target of the year-end. If London does not get its way, it could even block the banking union.

* Ultimately, a banking union is expected to establish financial backstops or central funds, paid into or guaranteed by banks or governments, to back problem lenders and shield savers.

In the meantime, it is expected that the ESM will provide a backstop after supervision is in place. Hungary, one of the countries outside the euro that is considering joining the scheme, is arguing that its banks should get access to that fund too, officials told Reuters.

Its demand highlights a fault line for the scheme: How to grant financial backing for banks in the euro zone as well as for outsiders that join.

* Even if a system of cross-border supervision is established, the other steps needed to complete a banking union are a long way off.

Establishing a unified deposit-guarantee scheme would be a major stumbling block, with Germany regarding a single guarantee as akin to the mutualisation of euro zone debt -- something it firmly opposes.

Setting up a scheme for the resolution or winding up of troubled banks is similarly problematic because it would require a central fund to bear the costs.

(Reporting By John O'Donnell, editing by Mike Peacock)

Copyright 2012 by Reuters. All rights reserved.


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