* EU ministers mull proposal to balance ECB powers in banking union
* Top German regulator warns supervision framework needs extra year
* ECB's Draghi says expects one-year phase-in of new system
(Adds detail on EU proposal, background)
By John O'Donnell and Edward Taylor
LUXEMBOURG/ FRANKFURT, Oct 9 (Reuters) - European Union ministers examined a proposal on Tuesday to limit planned new powers for the European Central Bank to supervise lenders, in a bid to allay the concerns of countries outside the euro zone over a new banking union.
The diplomatic drive came as the President of the ECB and Germany's markets regulator cautioned that setting up a new system of supervision would take up to the end of next year, later than many expected and a potential setback to efforts to help distressed euro zone countries and their banks.
Brussels proposed earlier this month that the ECB take charge of supervising all banks in the euro currency zone in stages from January, as a first step towards creating a banking union under which chiefly euro zone countries would eventually jointly back their lenders.
Winning broad support for a prompt introduction of the new supervision framework is important because it should allow the euro zone's rescue fund, the European Stability Mechanism (ESM), to directly inject much-needed capital into banks, such as those in Spain.
However, the plan has sparked concerns among the 10 EU countries which do not use the euro that they will be indirectly affected by the ECB's new supervisory powers and put at a competitive disadvantage, whether they join the scheme or not.
On Tuesday, diplomats from Cyprus, the current holder of the European presidency, delivered a proposal to change the blueprint for banking supervision, a move, in the words of one EU official, to make it more "digestible" for countries outside the euro.
In the document, seen by Reuters, they recommend a counterweight to the central bank's authority to withdraw a bank's licence, the ultimate threat a supervisor holds, by giving national regulators a large say in such a decision.
They also suggest a way for countries outside the currency area that choose to join the banking union, subjecting lenders to ECB control, to leave it again, by allowing them to "request the ECB to terminate the close cooperation at any time".
Speaking to journalists after the meeting, Michel Barnier, the European commissioner in charge of regulating banks, called for "flexibility and imagination" in reaching a "fair" system for those countries outside the euro zone to participate.
Barnier is aiming to reach agreement on the new supervisory system by the end of this year. But Mario Draghi, the president of the ECB, cautioned on Tuesday that setting up a new framework of supervision would take longer.
"The ECB is not supposed to take over supervision in three months' time and do it," Draghi told lawmakers in the European Parliament. "There is a phase-in time. We foresee that one year will be needed to adapt all the structures."
Elke Koenig, head of Germany's markets regulator BaFin, also warned that the original deadline to start such supervision by the beginning of next year was unrealistic.
"I could imagine that we get there in January 2014. That's a guess," she told German television station ARD on Tuesday, advocating a cautious approach.
"I support the idea of a strong European regulator. But I have not seen a roadmap of how we get there," she said.
"The last thing we can afford is to have an interregnum between those who are no longer responsible (for supervision) and those who are not yet in a position to act."
WORD PLAY Others urged quick action.
The Dutch central bank said on Tuesday that policymakers should quickly allow the European Central Bank to supervise major lenders and to enable the ESM to directly recapitalise troubled banks.
Gerard Rameix, head of the French markets watchdog AMF, said that he had heard nothing to suggest there would be a change to the timeframe.
"I think they are playing on words a bit. If they are talking about the utmost end of the process, then they are maybe not wrong," Rameix said.
As a first step, the ECB is set to take responsibility for supervising banks which have received state aid beginning 2013. From mid-2013 the ECB will add systemically relevant institutions, before finally overseeing all euro zone banks by 2014.
Germany, the euro zone's economic heavyweight, has criticised efforts to allow the ECB to supervise all euro zone lenders, claiming it will be overstretched.
In reality, the ECB will not be in day-to-day charge of supervision, which will still lie with national regulators, but will have the power to overrule those authorities.
The close ties between some troubled governments and the banks they supervise - and on which they also rely to buy their debt - have dragged both ever deeper into crisis.
A banking union would break this link by making the policing of banks supranational and establishing central schemes paid into collectively to cover the costs of closing failed lenders and protecting savers' deposits.
(Additional reporting by Kerstin Doerr in Berlin; Jean-Baptiste Vey and Lionel Laurent in Paris; Jesus Aguado Gonzalez in Spain, Stephen Jewkes in Italy.; Editing by David Cowell)
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Keywords: GERMANY BANKS/WATCHDOG