* Draft proposal waters down plan to EU deposit insurance scheme
* Commission plans stricter rules to reduce bad loans
* Large funds to be overseen by ECB under new plan (adds details from report, context)
BRUSSELS, Oct 5 (Reuters) - The European Commission is set to propose next week a watered-down plan to decrease risks in the banking sector in a bid to break a years-long stalemate as the main opponent to the project, Germany's Wolfgang Schaeuble, prepares to quit.
The plan tries to reduce bank risks after a decade-long economic crisis, and at the same time urges EU states to share those risks - an intent long opposed by Germany's departing finance minister who feared wealthier German banks would end up propping up weaker rivals in other EU states.
After two years of fruitless talks, the EU executive commission will make a new attempt to overcome the deadlock with new proposals which are expected to be published on Wednesday.
A so-called European deposit insurance scheme (EDIS), meant to cover insured savers (up to 100,000 euros) in case of a bank failure, should be introduced more gradually than initially planned, the commission said in a draft document seen by Reuters.
In a further move to win over Germany, whose new finance minister may be as sceptical as Schaeuble on the plan, Brussels is discarding initial plans for a full sharing of depositors' protection.
Under the new proposals, EDIS would initially intervene only after national insurance schemes have fully used their resources to rescue depositors. In this initial phase, EDIS would only provide loans to national insurers.
In a second phase, the common insurance scheme, funded by all EU banks, would cover losses and pay back deposits to savers hit by a bank collapse. National insurance schemes would continue to provide funds alongside EDIS.
A third and final phase, in which EDIS would have fully replaced national schemes, has been scrapped by the EU executive, after German pressure fuelled by fears that smaller savings banks in Germany would have lost their own corporate protection system.
In another move to increase risk-sharing among EU states, the Commission repeated that the European state bailout fund, the European Stability Mechanism, would be the best option as a backstop for the European Single Resolution Fund, which finances orderly bank liquidations. Brussels wants a deal on this by next year.
In a further offer to Berlin, EDIS second phase would only start after banks in weaker states have properly cleaned their balance sheets from bad loans, which are still weighing on lenders in Italy, Greece and other EU nations, although they are gradually decreasing.
The commission said that a threshold could be set for the maximum level of non-performing loans (NPLs). "Banks not meeting the threshold would be required by supervisory authorities to prepare NPL strategies with clearly defined quantitative targets," the document said.
To tackle the bad loan problem, the commission will also propose by Spring legislative measures to facilitate banks' recovery of soured credit, which could include "permission for banks to agree with business debtors on swift out-of-court collateral foreclosure".
It will also propose further development of a secondary market for bad loans, so that banks can sell them at higher prices.
The EU executive said it was also considering "minimum levels of provisioning which banks must make for NPLs", a measure that would reduce bad loans' risks but increase costs for banks.
FUNDS AND BONDS
In the 17-page draft document, the Commission also said it would propose that the European Central Bank extend its supervisory powers to large investment firms and funds. It already directly oversees the 130 largest banks in the euro zone.
The legislative proposals on stricter oversight of hedge funds and other large investment are expected by the end of the year, the document said.
To further increase financial stability and reduce risks from excessive bank exposure to the debt of their sovereigns, the commission said it will consider proposing in 2018 a legal framework for the so-called sovereign bond-backed securities (SBBS).
"By pooling and possibly tranching sovereign bonds from different member states, SBBS could support further portfolio diversification in the banking sector," the commission said.
(Reporting By Francesco Guarascio, editing by Jan Strupczewski)