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EU leaders inch closer to banking union deal

There were mixed messages coming from Brussels on Tuesday, as European finance ministers attempted to hammer out a deal on how to wind down failing banks, in an effort to protect the region from another economic crisis.

The proposed pan-European banking union is set to dominate talks at a meeting of the European Union's (EU) 28 finance ministers, known as the Ecofin, in Brussels, Belgium, on Tuesday.

But details of the plan have proved controversial, with countries such as Germany - the euro zone's biggest economy and therefore the largest contributor to rescue efforts - opposed to a system which would see failing banks tap a euro zone rescue fund. This part of the union, known as the Single Resolution Mechanism (SRM), would give a single authority the power to wind down struggling euro zone banks.

(Read more: Germany blamed for banking reform delays)

Joerg Asmussen
Sean Gallup | Getty Images
Joerg Asmussen

European Central Bank (ECB) board member Joerg Asmussen said he does not expect a deal on the SRM on Tuesday¸ despite a year-end deadline looming.

"I would expect that on the single resolution mechanism we will manage to narrow down the differences today," he told CNBC.

"It will be very likely a long evening but I do not expect that we will reach a final agreement already today."

Banking union is designed to take the burden of rescuing shaky banks off the shoulders of debt-laden countries – one of the main causes of the euro zone's financial crisis – by moving supervision of the financial sector to a European level.

Under the proposed system, major depositors in failing banks would be the first to be tapped in an effort to stump up the lender, in a Cyprus-style "bail-in" process.

Then, if more cash was needed, national rescue funds generated by individual countries would be used. Only if that fails would a common euro zone fund be called upon. The ECB is due to start overseeing this process – in what is known as the "Single Supervisory Mechanism" – in the autumn of 2014.

But Nicholas Spiro, managing director of Spiro Sovereign Strategy, said there were potential issues, even with the bail-in process.

"While the shift to a bail-in regime for vulnerable banks is necessary - and should have happened a long time ago - it's very unclear whether markets are ready for this, particularly when it comes to vulnerable Spanish and Italian banks," he told CNBC.

Compromising results?

Swedish Finance Minister Anders Borg said that all the ingredients were present for an agreement on banking union, but warned of the dangers of a "weak compromise."

(Read more: ECB's Draghi: New bank stress tests 'just the beginning')

"The most important thing for us is to see an end to fragmentation and a strong recovery. So a broad-based solution that is inducing confidence in the banking system is what we are aiming for," he told CNBC.

"But there is a great risk that we will once again fail to reach the necessary conclusions and therefore we will continue to see a very weak recovery in the euro zone, where the banking sector in some of the countries will remain very weak."

Carsten Brzeski, senior economist at ING, also said the "optimal solution" was unlikely.

"The messages coming out from the meeting are still hard to digest. How I read it now is that we will get a second-best solution," he told CNBC.

Spiro agreed, adding: "You can bet your bottom dollar that whatever deal emerges is going to be a classic EU fudge that conspicuously falls short of the mutualization of risks, thereby undercutting the whole rationale behind a proper banking union."

(Read more: Trichet: Banking union needed 'as soon as possible')

Agreement on both a euro zone resolution authority and rescue fund was unlikely, according to Brzeski, who said that ministers were instead likely to agree upon a mixture of national and euro zone responsibilities.

"Instead of a clear sweep which transfers national responsibility away to a euro zone level, it will be a gradual process in which national governments still have the final say," he said.

Another Ecofin meeting early next week is likely, according to Brzeski, where the final details of a banking union will be decided.

By CNBC's Katrina Bishop. Follow her on Twitter @KatrinaBishop and Google

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