Germany and France are split ahead of crucial summit talks on Sunday over how to strengthen shaky European banks and fight financial market contagion to prepare for a possible Greek default.
Under strong U.S. and market pressure, Chancellor Angela Merkel and President Nicolas Sarkozy will try to bridge sharp differences on how to use the euro zone's financial firepower to counter a sovereign debt crisis that threatens the global economic recovery.
A German source said Paris wanted to tap the euro zone's 440 billion rescue fund to recapitalize its own banks, which have the largest exposure to peripheral euro zone debt, while Berlin insisted the fund should be used only as a last resort when no national funds are available.
After meeting Dutch premier Mark Rutte, Merkel confirmed the German position was that the European Financial Stability Facility was a backstop to be used "only if that country is unable to cope on its own."
Merkel said struggling banks should set look first to the markets, then their national government, and only in the last instance the EFSF, and with reforms as a strict condition.
"This will definitely be discussed at the next summit," she said, referring to an EU leaders meeting on October 17/18 for which she and Sarkozy will attempt to set the agenda.
There was no immediate comment from Paris, where the government and the Bank of France, which regulates French lenders, had dismissed any need for recapitalization until this week.
A senior EU diplomat said the dispute surfaced in a tough discussion among euro zone officials this week over whether the EFSF could be used for banks on a "precautionary" basis or only "ultima ratio" (as a last resort).
The Brussels diplomat said France's approach was dictated by its determination to limit any risk to its AAA credit rating. France has the highest debt-to-GDP ratio of any of the six triple-A countries in the euro zone at 86.2 percent.
"The bottom line for France is the AAA, and that's why the are pushing to do it (recapitalization) through the EFSF," he said.
If France, the second largest guarantor of the rescue fund after Germany, were to lose its top-notch rating, the whole edifice of financial support for Greece, Portugal and Ireland would crumble.
Many major European bank continue to insist they need no more capital although the International Monetary Fund says up to 200 billion euros must be injected.
The chief executive of Societe Generale told Reuters Insider TV the main problem for banks was not one of capital but liquidity as interbank lending dries up.
"The main issue is a crisis of confidence in the sovereign ... What is important is to deal with the Greek issue as quickly as possible and then rebuild confidence in the capacity of each bank in Europe to reduce its debt," Frederic Oudea said at his offices at SocGen's Paris headquarters.
"My view is ... the potential recapitalization will not sort out the issue of confidence in the sovereign debt."
Some banks are clearly in need, however.
France and Belgian are arguing over whose taxpayers should pay to salvage cross-border municipal lender Dexia, which came close to collapse this week and is to be broken up.
U.S. President Barack Obama implored European leaders on Thursday to come up with a plan before a Group of 20 major economies summit in Cannes, France, on November 3-4, saying the euro zone crisis was the biggest cloud over the U.S. economy.
European Commission President Jose Manuel Barroso said on Thursday the EU's executive arm was preparing a plan for bank recapitalization across the 27-nation bloc.
However, other EU officials have made clear it would only be a set of guidelines for national measures and an approach for cross-border banks, and not a common European mechanism or mandatory rules on recapitalization.
The European Banking Authority, which coordinates national regulators, is reassessing banks' capital buffers based on data provided for stress tests conducted in July, which showed that only eight banks failed, requiring just 2.5 billion euros in extra capital.
No statement was issued after a two-day EBA board meeting that ended in London on Thursday.
A euro zone supervisory source said a figure of 180-200 billion euros cited by International Monetary Fund and private economists reflected the impact of writing down sovereign bond holdings to current low market prices and assuming that Greece and perhaps another country would default.
"If you mark to market and allow complete defaults then you get to these 180-200 billion," the source said.
Both Merkel and Sarkozy have reaffirmed in the last week that a Greek default must be avoided because it would have potentially catastrophic consequences for the European and global economy.
"A failure of Greece would be a failure for all Europe," the French leader said last week. "For both economic and moral reasons, we can't let Greece fail."
Merkel has been more circumspect, saying Germany would do everything possible to support Athens if it sticks to its IMF/EU bailout program, but she has acknowledged that a sovereign default cannot be ruled out.
A team of EU and IMF inspectors is continuing negotiations with Greece on reforms required to release a vital 8 billion euro aid installment by mid-November.
The head of the IMF mission said on Friday he hoped a review of Greece's progress under the bailout deal would be concluded positively soon, but talks were not yet finished.
"We have made good progress but there are still important issues that need to be discussed," the IMF's Poul Thomsen told reporters. "Hopefully, we will conclude positively soon, but we are not there yet."