UPDATE 2-With Germany onside, EU nears banking union deal
* EU ministers meet in Brussels in bid to break impasse
* ECB supervision first step towards closer integration
* Cyprus proposes compromise on ECB supervision
BRUSSELS/BERLIN, Dec 12 (Reuters) - Germany signalled on Wednesday it was ready to back plans for the European Central Bank to be made the chief supervisor of banks, raising the prospect of a breakthrough on the European Union's most ambitious financial reform.
Finance Minister Wolfgang Schaeuble told the German cabinet he was "optimistic" about a deal ahead of a meeting of EU finance ministers in Brussels on Wednesday, a German official said, speaking on condition of anonymity.
"We hope for major progress and perhaps a breakthrough (in the talks)," he said. "We have some questions but if they can be resolved by finance ministers today then Germany will not stand in the way of an agreement."
After three years of piecemeal crisis-fighting measures, agreeing on a banking union would lay a cornerstone for deeper economic and fiscal reforms and mark the first concerted attempt to integrate the bloc's response to problem banks.
A single banking supervisor for the euro zone and most other EU states would be a crucial step towards that goal, although other issues such as a resolution authority for failed banks, a backstop fund and joint deposit insurance will remain.
France and Germany had been at loggerheads over parts of the plan, but with little time left for the EU to meet a commitment to complete the framework for banking union by the end of the year, both countries redoubled efforts to settle their differences in late night negotiations on Tuesday.
Among the outstanding questions that ministers must settle are how many banks the ECB should directly supervise and whether the central bank gets longer than one year, as planned, to take on its role.
Reaching a deal, which EU leaders hope to sign off at a summit on Thursday and Friday, will also require the backing of others with vested interests such as Britain, Sweden, Poland, Hungary and the Netherlands.
Berlin has dragged its feet for months due to concerns that it will be left to foot the bill for European banks too weak to survive when, as is planned at a later stage, a central resolution scheme is set up to close troubled banks.
It remains worried about a potential conflict of interest between the ECB's roles as supervisor and as guardian of monetary policy. Such a conflict could arise if, for example, the ECB were to keep interest rates low to prop up banks.
In a sign of tensions last week, Schaeuble clashed publicly with French Finance Minister Pierre Moscovici at a meeting intended to finalise the plan. France wanted quick steps towards banking union; Germany said quality must come before speed.
Among his firmest objections is Schaeuble's opposition to the ECB's Governing Council having the final say over monitoring banks, a position that pushed talks backwards. But there are signs he is ready to soften that stance.
France also has demands. "We can envisage degrees of supervision depending on banks' size, but on one condition -- that in the end the European Central Bank holds the ultimate responsibility," Moscovici told Reuters this week.
Britain remains concerned about the scheme. The EU Committee of Britain's upper house of parliament stressed in a report the need for London to obtain safeguards to ensure its large and influential banking sector was not put at a disadvantage.
"I think the UK government has to wake up and go into battle for Britain and for the City of London," committee chairman Lyndon Harrison told Reuters.
In particular, London wants to change the system of voting when regulators from across the European Union meet to flesh out EU law, such as defining in detail the type of capital reserves that qualify as a cushion against banks' risky assets.
The regulators meet under the umbrella of the European Banking Authority, but Britain is concerned that euro zone states -- united under the supervision of the ECB -- would vote as a bloc to force through rules that work in their favour.
London has demanded that countries outside the single currency be able jointly to block certain decisions taken by the ECB, a veto that is opposed within the euro zone.
Swedish Finance Minister Anders Borg, who had previously questioned the legal basis of the scheme, said that while his country was unlikely to join, it may allow other countries to press ahead if pan-EU voting safeguards are in place.
Several officials said it was still possible that Sweden would give its backing on Wednesday, even if it doesn't join the scheme from the start.
PILLARS FOR UNION
Cyprus, which as holder of the rotating EU presidency chairs the meeting, will put a compromise proposal to the ministers, prepared in close consultation with Germany, France and Britain.
An EU diplomat with knowledge of the discussions was upbeat about the prospect of bridging differences. "We are very optimistic that we can reach a deal," he said.
The compromise document, obtained by Reuters, recommends that banks with assets of 30 billion euros or with assets larger than one fifth of their country's economic output be supervised directly by the ECB rather than national supervisors.
Banks with subsidiaries in at least two other states in the banking union would also be in that category. Critically, however, they leave the ECB with the authority to widen this remit to problem banks even if they are smaller.
Dutch Finance Minister Jeroen Dijsselbloem said it was crucial that the ECB have the power to intervene in small banks if problems arose, without the interference of national authorities or supervisors.
The central bank's Governing Council would keep the final say in supervision, according to the proposal, which also lays emphasis on the need for a clear separation between monetary policy and supervision.
The compromise proposes that each country in the banking union have at least two banks supervised by the ECB.
Ministers will also consider allowing the ECB more time than until Jan. 1, 2014 to fully take on its role.
EU leaders hope that by setting up a single banking authority and later establishing a resolution fund, they will stop troubled banks from dragging their countries into crisis. They also hope to coordinate national deposit guarantee schemes.
While most countries support the idea of supervision, which is the first pillar of a full banking union, they have disagreed on how to structure it and how far to go in sharing bank risks.
All 27 EU states must give approval for the project to go ahead, even if only those countries in the euro zone will fall under the banking union to begin with.