ANALYSIS-German plan may weaken European banking union
* Germany wants to limit scope of agency to close, salvage banks
* Berlin wants agency to work only with biggest banks
* Proposal keeps banking union negotiations alive
* But plan would side-step perils of small banks
BRUSSELS, Sept 16 (Reuters) - A German plan to scale back a major element of European banking union may reinvigorate the ambitious project, but also threatens to compromise its ability to prevent future crises.
If Berlin's idea prevails, the resulting banking union would fall well short of what European leaders originally envisaged as their response to the 2008 financial crisis, leaving small but risky banks outside the scheme.
"If you are going to have true banking union, it should be a union for all banks," said Alan Ahearne, an economist who advised the Irish government as it faced the collapse of its financial system.
While European leaders have endorsed the concept of banking union, creating a system that would move banking supervision and dealing with banks in trouble from a national to European level has proved much harder. Deposit guarantees are excluded for now.
Euro zone officials told Reuters that Berlin is working on the plan that would allow completion of the project without changing the European Union treaty, something that would almost certainly be long and complex.
Germany is suggesting that a new "resolution" agency to wind down or salvage bad banks should have power only over the euro zone's largest lenders, scaling back its reach to around 130 institutions, rather than all 6,000 in the currency bloc.
Ahearne said this would leave unsolved a fundamental requirement for restoring confidence in the European banking system after the taxpayer-funded bailouts during the crisis.
"Governments like to have control over their own banking systems. That's where a lot of the problems come from. These decisions have to be made at a European level," he said.
Germany, the largest and most powerful euro zone country, is worried it will be liable for problems in other countries' banks if the resolution agency has too much scope. Berlin also wants to keep responsibility for its own savings banks.
The European Central Bank is due to take over supervising euro zone banks - the first element of the project - late next year, a move policymakers hope will help to restore confidence.
Berlin has already ensured that the ECB has direct oversight of only the largest 130-150 "systemically important" banks, and now wants the resolution agency to have the same limits on its powers.
The European Commission's top financial regulatory official, Michel Barnier, stressed the project's urgency on Monday.
"We need to get the resolution system up and running as quickly as possible," Barnier told the European Parliament. "We have to be prepared to handle any manner of crisis. We need to remember what we have learned from having to bail out banks with their backs to the wall."
Limiting the scope is important for Germany since the resolution agency, once fully operational, could demand that a bank be closed down. That could prompt a request for help from the euro zone's rescue scheme, the European Stability Mechanism, of which Germany is the biggest shareholder.
While Germany's desire to limit its own liability is understandable, it runs the risk of hampering the work of the ECB in tackling wider banking problems.
If, for example, the ECB identifies shortcomings at a smaller bank - defined here as one with assets of less than 30 billion euros - it would struggle to force its closure without the resolution agency to back it up. But if this agency is responsible only for the largest 130-150 banks, it would not be in a position to back the ECB up on a small bank.
"There is no magic line dividing banks which are systemically relevant and those that are not," said Johannes Wassenberg of credit ratings agency Moody's.
"The question for the market is, how far is the state liable for these banks?" he said, warning that such a compromise would undermine the aim of ending the damaging link between indebted countries and their troubled banks.
"If the resolution decision is carried out on a national level for these banks, then this central goal of banking union has been watered down."
Charles Goodhart of the London School of Economics also questioned the wisdom of excluding small banks, citing the example of Spain's cajas. These regional savings banks, many of which ran into trouble when the property market collapsed, were responsible for forcing Madrid to seek international aid.
But under the German proposal, the cajas would not fall either under the ECB's direct supervision or under the resolution agency's purview.
"If you have a large number of small, weak banks, that can cause a problem as well," said Goodhart.
Berlin's problem is partly political. Any suggestion of signing up to a scheme that increases its liability would be unpopular with Germans, who vote in national elections on Sept. 22. Policymakers in Brussels hope that the proposal from Berlin will form part of a negotiation in the next few months.
"The line of the German government is to do joint supervision but to stop at any common responsibility," said Sven Giegold, a German Green member of the European Parliament.
One EU official signalled that limiting the resolution agency's reach was a compromise that Barnier may accept.
The big banks that would be covered by direct ECB supervision and the new wind-down agency would still account for roughly 85 percent of the euro zone's banking system.
"This is a glass that is two thirds full," said Daniel Gros of the Centre for European Policy Studies think tank. "I can imagine that it fills up over time."
(editing by David Stamp)