Last month, the European Commission proposed making the ECB responsible for supervising lenders as a step towards a banking union where chiefly euro zone countries would jointly tackle problem banks and shield savers' deposits.

But the proposal, central to closer economic integration in the currency area, has encountered opposition in Britain that could delay or even derail banking union.

Britain intends to propose a system that would give countries outside the banking union the possibility of blocking those within the project from clubbing together to shape EU-wide regulations, said EU officials, speaking on condition of anonymity.

"The concern is that the Bank of England can find itself outvoted by the ECB on aspects of rule making," said one official. Britain will not join the banking union. The Bank of England will become the UK regulator next year.

"They are worried that the euro area will be able to push through a whole lot of decisions of its own volition. They are looking for something with checks and balances."

Although the discussion is technical, it is highly politically charged. Speaking privately, a second EU official said it could further sour an already strained relationship between Britain and the bloc.

The banking union would have three major steps: the ECB takes over monitoring euro zone banks and others that sign up; a single fund is created to close down and settle the debts of failed banks; and a comprehensive scheme to protect savers' deposits is established.

As well as building the foundations for better control of banks, the new supervision should also allow the new euro zone rescue fund, the European Stability Mechanism (ESM), to directly inject capital into struggling banks, such as those in Spain, breaking the interdependence between weak banks and indebted nations that has fuelled the regional crisis.

Officials from the European Union's 27 countries met in Brussels last week to discuss the extent of the ECB's powers under the new structure and what authority should remain with national regulators.

They also addressed one of the key obstacles to the project - how to cater for the 10 EU countries that are not in the euro zone and allay their fears that they could be sidelined in the new structure.

Britain favors a banking union because it should unite all 17 countries using the euro behind problem banks and end the previously haphazard approach that left weak states such as Ireland to shoulder the cost of propping up banks themselves.

But Britain's finance minister, George Osborne, fears the ECB will use its authority to impose EU-wide regulation that would favor countries with the euro and put London's financial centre, using sterling, at a disadvantage.

"It seems unlikely that the ECB would ride roughshod over the wishes of the Bank of England, but that is what the British Treasury is worried about," said the first official. "They want safeguards to make sure that doesn't happen."

BREAKING POINT

Britain and all other members of the European Union must give the green light to the banking union before it can go ahead, an approval that could be delayed or withheld if London's concerns are not addressed.

In particular, London is focused on changing the system of voting when regulators from across the European Union meet to flesh out EU law, such as defining in detail the type of capital reserves that qualify as a cushion against banks' risky assets.

Those regulators meet under the umbrella of the European Banking Authority, but London is concerned that countries in the euro zone - united under the supervision of the ECB - would use their combined clout to force through rules that work in their favor.

They would like to see a double vote take place - one for those in the banking union and another for non-euro countries outside - before any final decision on EU regulation is taken. This could offer those countries outside the scheme an effective veto.

A spokesman for the British Treasury said: "We've consistently said that the euro area, like any single currency, needs closer economic and fiscal integration to secure its future. More integrated supervision of euro area banks is a part of that."

"We've also been clear that any measures must be compatible with the single market, and uphold a level playing field for all EU member states."

Britain's concerns about banking union and the political direction of the wider European Union threaten to create a significant obstacle to building one of the central planks in the euro zone's response to the crisis.

Britain has often fought with Brussels over regulation. But as the mood in his ruling Conservative Party has hardened against Europe, relations have become increasingly frayed.

Earlier this year, British Prime Minister David Cameron refused to sign up to a fiscal pact for strict budget discipline in the euro zone after similar demands he made to protect London's financial center were rejected.

EU leaders will meet this week on Thursday and Friday, and banking union is among the issues they are set to discuss.

(Additional reporting by Matt Falloon; Editing by Will Waterman)

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