European Commission President Jose Manuel Barroso outlined the proposal in his annual "state of the union" address, laying out a path to further economic integration that he said he hoped would underpin the future of the euro currency.

The proposed banking reforms, which need to be approved by the European Union's member states, aim to break the link between banks and states, preventing heavily indebted countries being sucked further into difficulty by distressed lenders in need of rescue.

It tackles a core element of the crisis that first struck banks in Europe almost five years ago and escalated into a sovereign debt crisis in 2010.

"The crisis has shown that while banks became transnational, rules and oversight remained national," Barroso told members of the European Parliament. "We need to move to common supervisory decisions, namely within the Euro area."

"The single supervisory mechanism proposed today will create a reinforced architecture, with a core role for the European Central Bank," he said. "It will be a supervision for all Euro area banks."

For the plan to work, it will require countries to surrender a degree of sovereignty over supervising their banks. This has long been a national responsibility, and the proposal has already led to tensions with Germany and Britain.

Although Britain, which is outside the euro zone, will not join the scheme, many international banks in London have operations in the euro area that will be affected by the ECB's new supervisory reach.

London is also worried that the ECB, emboldened by its new powers, will demand regulation that could undermine the city's position as Europe's de facto financial capital. Similar concerns are shared by countries such as Sweden.

"We've said that a banking union for the euro area must also respect the integrity of the single market for the whole of the European Union," said a spokesman for the British Treasury. "We'll ensure the agreement on it does that."

Underscoring the sensitivity of this issue and its potential to upset the new banking framework, the European Commission has suggested the creation of a special voting mechanism among all EU regulators as a counterbalance to the power of those in the euro zone.

"We absolutely want to avoid the feeling that what we are doing means that the ins and the outs should be confronted with different interests or different agendas," said one EU official.

A banking union foresees three steps: the ECB getting the power to monitor all euro zone banks and others in the wider EU that agree to the oversight; the establishment of a fund to close troubled banks; and a fully fledged scheme to protect citizens' deposits across the euro zone.

Establishing a common framework for dealing with problem banks would mark a departure from the previously haphazard approach taken by the euro zone's 17 members that has frustrated investors and helped drive up borrowing costs for weaker states.

Handing powers of supervision to the ECB also unlocks the possibility of direct aid to banks from the euro zone's permanent rescue scheme, the European Stability Mechanism (ESM), although it is not clear when Spain and others would benefit.

The Spanish government, which has already been offered up to 100 billion euros ($128 billion) in European aid to rescue its most troubled lenders, welcomed the proposal on Wednesday.

APPREHENSION

Under the terms of the proposal, the ECB would be at the head of the currently fragmented system of national regulators, with the power to police, penalize and even close banks across the euro zone.

The ECB would also gain powers to monitor banks' liquidity closely and require them to keep more capital to protect themselves against future losses.

Reaching agreement on the terms of the union could be complicated, delaying the introduction of the new regime beyond the target set by euro zone leaders of the beginning of next year.

Germany, the euro zone's economic heavyweight, is opposed to allowing the ECB supervise all euro zone lenders.

Berlin says the central bank will be overstretched if it has to monitor all 6,000 euro zone banks. Commission officials argue that even small banks can cause a wider crisis, as happened with the bank run on Britain's Northern Rock in 2007.

The Commission's proposal foresees a phasing in of this supervision over a year and says the ECB should be able to police all banks. The ECB should begin monitoring half of the euro zone banking sector from the middle of next year.

Banks in Britain are also apprehensive about the impact of the new regime.

"The single market is Europe's biggest asset," said Anthony Browne, Chief Executive of the British Bankers' Association.

"Any splintering into a two-tier financial services market would threaten the ability of businesses across Europe to raise money for investment and would hamper economic recovery."

($1 = 0.7785 euros)

(Writing By John O'Donnell; additional reporting by Huw Jones and Steve Slater in London and Fiona Ortiz in Madrid; Editing by Will Waterman)

• A Permanent Economic Emergency