UPDATE 1-Germany challenges European blueprint for banking union
* 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
* Berlin to accept ESM bank aid only after changes to law
(Adds detail from meeting, Asmussen remarks)
BRUSSELS, Nov 15 (Reuters) - Europe's attempts to complete a banking union encountered opposition on Friday from Germany, which demanded that countries and investors bear the brunt of repairing stricken lenders to spare the use of euro zone funds.
Berlin's objections to using euro zone money, backed only by Finland and opposed by France and Spain, threaten to undermine Europe's attempt to tackle troubled banks and spoil tests next year intended to make a clean sweep of their problems.
Germany is trying to pare back a central plank of banking union, namely that the euro zone clubs together to tackle weak banks. Instead, it wants losses imposed on bank creditors, including bondholders, once stress tests name the weaklings.
As EU ministers held a second day of talks, Germany's finance minister toughened his stance on the use of euro zone money to help stricken lenders, people close to the talks said.
Ministers want a joint statement outlining how they will deal with troubled lenders after bank health tests next year.
But the discussion became acrimonious as a rift emerged 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.
German finance minister Wolfgang Schaeuble struck out at the idea of a euro zone backstop, seen as a way to avoid a repeat of what happened in Ireland, which needed an international bailout when it buckled under heavy bank debts.
He challenged an earlier agreement that the euro zone's rescue fund, the European Stability Mechanism (ESM), could provide aid directly to banks rather than via governments.
One person present cited Schaeuble as warning that it would be a "huge misunderstanding" to believe that the ESM could back a bank in difficulty. On Thursday, he had told reporters any such move would breach German law.
Europe's most ambitious reform since the start of the euro currency would see the European Central Bank 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.
Schaeuble's blunt message surprised many as the common backstop is a key demand of some of Europe's biggest countries - France, Italy and Spain. 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.
Sweden's Finance Minister Anders Borg also delivered a sharp retort to such a watering down. "There has to be some sort of euro zone backstop," he told reporters. "Otherwise the whole operation seems pointless."
In a compromise, Schaeuble conceded that a reference to possible direct ESM bank aid could be included in a statement from ministers due to be made later on Friday - although only on condition that changes to national law are made first.
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 - could 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. That would need strong states such as Germany to support weaker countries grappling with bank problems.
"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."
Asmussen outlined a possible compromise last week in a speech in Berlin, including the proposal that the remit of a new European agency to close banks could be limited to top banks only - a key German demand.
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.
(Additional reporting by Adrian Croft, Martin Santa, Robin Emmott and Jan Strupczewski in Brussels and Annika Breidthardt in Berlin; Writing by John O'Donnell; Editing by Catherine Evans)