German bid to weaken banking union gets frosty reception
* German bid to dismantle euro zone safety net meets stiff resistance
* Stress tests next year set to come clean on banks in trouble
* ECB underlines need for back-up plan for banks that fail
BRUSSELS, Nov 15 (Reuters) - Germany found itself isolated on Friday in attempting to overturn a central plank of banking union, encountering heavy resistance to its bid to prevent the use of euro zone funds to repair troubled lenders.
Berlin's objections, backed only by Finland and opposed vehemently by France and Spain, risk undermining pan-European efforts to forge a plan for stricken banks and spoiling tests designed to make a clean sweep of their problems.
As EU ministers gathered for the second day of talks to outline plans to deal with troubled banks, Germany's finance minister toughened his stance on the use of the bloc's emergency fund, according to people close to the discussions.
Ministers had been drafting a joint statement to outline their plan of action after bank health tests next year.
But the discussion drove a rift between France, which wants a euro zone safety net, and Germany, which is worried that it will shoulder much of the burden if weak countries turn to the bloc's emergency fund.
Many consider a euro zone backstop central to a banking union to avoid a repeat of events in Ireland, which required an international bailout when it buckled under heavy bank debts.
Earlier this year, euro zone countries agreed that their rescue fund, the European Stability Mechanism (ESM), could provide direct aid to banks, not just indirectly by lending to governments.
This is a key demand of some of Europe's biggest countries - France, Italy and Spain. As he entered the meeting on Friday, French Finance Minister Pierre Moscovici vented his frustration.
"France wants a complete and ambitious banking union," he told reporters, calling for the "clearly-stated possibility to use the ESM for direct recapitalisations of banks".
"It is very important that this possibility exists and is clearly indicated," he said.
But Germany has dug in its heels. On Thursday, Wolfgang Schaeuble, Germany's finance minister, had dismissed such a move, saying it was not yet legally possible.
The sources said the two had clashed again inside the meeting room, when Germany asked for the removal of any reference to ESM bank aid from the ministers' statement. Moscovici was backed by Spain's Economy Minister Luis de Guindos.
The statement is due to be made later on Friday.
The dispute comes at a delicate moment in Europe's economic recovery and could yet stymie the banking union reforms.
Ireland and Spain, which both required international emergency aid to tackle their banking problems, will end those programmes in the coming weeks.
But bank health checks next year - by the European Central Bank and then by regulators across the wider European Union - are likely to reveal losses on loans and capital holes at banks.
By explaining how the clean-up will be paid for, ministers had hoped to reassure investors that they are ready to come clean on the bank problems that first struck Europe in 2007.
Their promise to stand ready with national backstops will be a hollow one, however, if it is unclear how countries which are too weak to prop up their banks alone can be helped.
Germany's objections worried the ECB, which wants to reduce banks' reliance on its cheap financial support. If strong states such as Germany do not support weak countries grappling with bank problems, that undermines those efforts.
"We always said it's absolutely necessary that we have a credible backstop in place," said Joerg Asmussen, the German member of the ECB's core six-man group that directs policy, commenting on preparations for bank health checks.
"We need three layers of backstops - first private markets, second domestic budgets or domestic bank rescue funds, and the third layer is the ESM."
A new pan-euro zone fund to pay for the costs of closing down or salvaging weak banks was intended to address this but Germany also made clear on Thursday that it did not want the ESM to lend to any such fund.
"We are very clear that we don't want a mutualisation of bank risks," one German government official said on Thursday, adding that talks between political parties in Berlin to form the next government meant Schaeuble had yet to receive a final mandate for negotiations.
Banking union, Europe's most ambitious reform since the start of the euro currency, would see the ECB policing lenders from late next year and should ultimately form a united front across the euro zone to back ailing banks or close them down.
Before any test result can be announced, the question of who pays for the costs of salvaging weak banks or shutting those not worth saving must be answered.
Time is running out for the ministers to strike a deal by their self-imposed deadline of the end of the year.
(Additional reporting by Adrian Croft and Jan Strupczewski in Brussels and Annika Breidthardt in Berlin; Writing by John O'Donnell; Editing by Catherine Evans)