A plan to create a single euro zone banking supervisor is illegal, according to a secret legal opinion for EU finance ministers that deals a further blow to a reform deemed vital to solving the bloc's debt crisis.
A paper from the EU Council's top legal adviser, obtained by the Financial Times, argues the plan goes "beyond the powers" permitted under law to change governance rules at the European Central Bank.
The legal service concludes that without altering EU treaties it would be impossible to give a bank supervision board within the ECB any formal decision-making powers as suggested in the blueprint drawn up by the European Commission.
Those non-euro zone countries that want to opt into the bank supervision regime would also be legally unable to vote on any ECB decisions — a key demand of countries such as Sweden and Poland.
While it is common for lawyers from different EU institutions to disagree on aspects of proposals, diplomats involved in the talks said the sharp difference in legal opinion would complicate efforts to overcome the deep-set concerns of some member states. Banking union will be a central topic at the EU leaders summit on Thursday.
In addition to spelling out the legal limitations facing euro zone "outs", the adviser's opinion will add to German concerns over the independence of the ECB monetary arm, as it casts doubt over establishing a separate decision-making process for supervision.
Berlin's demand for more voting clout on supervision matters is also undermined.
The legal opinion will add to German reticence over rapid implementation of the supervisor.
Parts of the paper, however, sketch out a possible legal compromise within the treaties, which EU officials are examining as a potential basis for tweaking the design of the supervision regime.
The legal service says that a board can be established that is tasked to "prepare" draft supervision decisions, as long as the final say remains with the ECB governing council.
This arrangement would allow non-euro zone countries to be given full voting rights, at least in the drafting of advice for the ECB to act on. This structure could be further strengthened if the ECB were to voluntarily delegate tasks.
Acknowledging the limits of the law, Michel Barnier, the EU commissioner responsible for the banking union proposal, has said previously: "The solution to these questions belongs in part with the ECB."
However, some officials involved in the talks were unimpressed with the prospect of voting powers for a committee that cannot take decisions, arguing it fell well short of a realistic political solution.
"Now it is clear they can't have a say, fewer outs are likely to join," said one. Another said the compromise was "hardly enticing".
While EU leaders are still aiming to agree the supervision plan by the end of the year, talks have made little progress to date, in part because of strong German objections. Some participants privately suggest the talks may drag on for a year or more.
Other elements of the commission proposal were also challenged in the legal opinion, notably in asserting the rights of member states to decide how rules on their banks are applied, even when under the supervision of the ECB.
"The major question that follows from this opinion is a practical one," said Alexandria Carr, a former UK legal adviser now at Mayer Brown International.
"Will the ECB have the capability and capacity to be the ultimate decision maker in respect of all supervisory decisions over complex, global institutions and to apply at least 17 different pieces of domestic legislation?"