Cyprus overshadows banking union as ECB prepares for watchdog role

EU lawmakers are set to empower the ECB this week to supervise banks from mid-2014, but they will struggle to reinstate a vision of wider banking union, shaken by a levy imposed on Cypriot savers.

Last year's agreement among countries to give the European Central Bank new powers to supervise euro zone banks from 2014 was initially applauded as a first step towards closer integration to help underpin the euro.

But as lawmakers from the European Parliament and EU states' negotiators meet on Tuesday morning to finalize the deal, questions are being raised about Europe's commitment to unite in tackling banking problems rather than let countries struggle alone.

"Things are coming to a head," said a senior euro zone diplomat involved in the discussions, while conceding that Cyprus had complicated future steps towards banking union.

He said the levy imposed on bank deposits in Cyprus to cut the cost of the country's financial bailout will make it harder to build another pillar of banking union - a scheme to close banks in trouble without leaving the burden on its home country.

"Cyprus is only going to make it more complicated," he said. "It raises a whole new set of issues. A loss for depositors is not just a hypothetical question any more."

On Tuesday, diplomats will seek to iron out the final issues on supervision. They center on the European Parliament's role in appointing the head of the new bank supervisory body and other measures to protect countries such as Britain, which will not join the ECB-led scheme.

Agreement on bank surveillance is a crucial first step towards a broader banking union, or common euro zone approach to dealing with failing banks that in recent years dragged down countries such as Ireland and Spain.

But Nicolas Veron, an expert in EU policy at the Peterson Institute for International Economics in Washington, said the "default on insured deposits" in Cyprus had undermined a central tenet of any such scheme.

"Clearly we don't have a banking union yet, even if we will have single supervision," he said. "Deposit guarantee is a central plank of that. I hope that lessons will be learned from this episode."

The next pillar of a banking union would be the creation of a central system to close troubled banks, backed by a common backstop. Setting up such a fund, however, would require the support of reluctant countries such as Germany.

A separate pledge by euro zone leaders to enable the bloc's rescue mechanism to directly recapitalize struggling banks once the ECB has taken on supervision also appears to be unraveling.

Again, Germany is worried it could be forced to foot the bill for struggling banks across the region.

Finland, the Netherlands and Germany want any banking problems that arise before the ECB takes over as supervisor to be disqualified, when it comes to applying for assistance from the European Stability Mechanism.

(Additional reporting by Robin Emmott; editing by Ron Askew)