By John O'Donnell and Eva Kuehnen
BRUSSELS/ FRANKFURT (Reuters) - It was billed as a reform that would tighten policing of Europe's banks and end their ability to suck states into crisis. Now fears are growing that a central element of banking union will be scaled back, undermining the whole scheme.
When it takes the role of watchdog for euro zone banks in March next year, the European Central Bank will be confronted with a financial system that is still limping. In some countries, such as Cyprus and Spain, it is in critical condition.
Setting up a fund and agency that, where needed, would shut weak banks - known as 'resolution' - is central to this ECB-led union because it would remove the onus on countries like Ireland to save failing banks alone, running up bills that overwhelm the state.
Yet the political drive to complete banking union is waning, with the reluctance of Germany and other economically-strong countries to put themselves on the line for bad loans made in Spain and elsewhere coming back to the fore.
"It's unrealistic to expect that we will have a resolution authority or resolution fund in time for the new ECB bank supervision in March 2014," said Sharon Bowles, an influential EU lawmaker who will help shape the new regime.
"That means that if there is a problem, it lands back at the national authorities," said Bowles, who chairs the European Parliament's economic and monetary affairs committee.
The problem is simple. "A resolution fund ... is the beginning of (debt) mutualisation and the Germans don't want to go there," said one EU official, pointing to a creeping complacency among politicians since the ECB defused market tensions.
"It's a very tall order to get it completed by the end of the year."
German national elections in September exacerbate the issue.
"Germany will not commit to anything before the elections," said Martin Lueck, an economist at UBS, adding that he was nonetheless cautiously optimistic that a deal could be reached afterwards.
Such a delay would bode ill for the ECB, the euro zone's bulwark against another markets storm. The central bank, which is propping up hundreds of banks across Europe with cheap loans, is growing nervous.
ECB President Mario Draghi stressed this week how important a move from a "purely national to a supra-national resolution mechanism" was, because many euro zone banks are operating extensively across borders.
ECB Executive Board member Benoit Coeure later called for EU countries to promptly set up a joint bank resolution mechanism, saying "2013 will be a key year for Europe to make progress with this second leg of the banking union".
The remarks underscore growing unease about the political resolve to build on an agreement among EU finance ministers last December that created the ECB watchdog.
That had been intended as the first step towards a banking union to sever the 'doom' link between nations and banks by ultimately forging a common front across all 17 countries in the euro zone to defend their currency and banks.
A draft blueprint for an EU resolution law - to deal with failed banks such as Dexia <DEXI.BR> - has already been produced by the European Commission.
In the coming months, the EU's executive will flesh this out with a roadmap to create a central agency to close laggard institutions and a means to pay for the costs involved.
EU countries want banks to pay into a fund to shoulder the cost of collapse. But while this backstop is being built, the euro zone's rescue fund, the European Stability Mechanism, may have to step into the breach.
But following the ECB's pledge to intervene to help struggling countries, markets have calmed, lifting pressure on politicians to make good on earlier promises to break the link between bank and state by sharing the cost of failing banks.
The reluctance of Germany, Finland and others to agree to such a backstop may have far-reaching consequences for the ECB.
For ECB supervision to work, it needs to be able to, in the words of Coeure, "identify failed banks". Yet, without a resolution fund to pay for a clean-up, it would be difficult if not impossible for Frankfurt to publicly name such weaklings.
It puts the bank in an uncomfortable position.
Throughout the crisis, the ECB has been forced to prop up the region's banks with cheap credit, lending them more than 1 trillion euros and funneling further 'emergency liquidity' through national central banks - Greek and Irish banks alone have taken more than 140 billion euros of such aid.
To do this, the ECB loosened its standards on the security it accepts, taking on car loans, consumer finance and commercial mortgages with a credit rating just above 'junk' in return for credit.
As supervisor, the ECB had hoped to reassert order on the sector, by demanding, for example, the closure of weak banks dependent on its support. Without a back-up scheme to cover the costs of shutting such banks, this will be all but impossible.
"Without banking resolution, there is no banking union," said John Fitzgerald of the Economic and Social Research Institute, a Dublin-based think tank.
"If you have centralized supervision, it must be for Europe and not individual countries to pay for any accidents."
The scaling back of banking union, firstly by removing a pillar for deposit protection and with a question mark now over the means to tackle failed banks, means that ECB supervision may be the only element left, at least at the outset.
The resulting regulatory mess could undermine faith in the bank more broadly as an institution.
"If the ECB makes supervisory mistakes or covers up the truth about banks because it does not have the support of a resolution mechanism," warned Guntram Wolff, an economist with think tank Bruegel, "then its credibility - and the currency - will suffer."
(Reporting By John O'Donnell and Eva Kuehnen; editing by Patrick Graham)