* Banking union plan would be step towards integration
* Proposal foresees ECB getting powers to police banks
* Germany voices reservations about wide ECB remit
By Claire Davenport
STRASBOURG, France, Sept 12 (Reuters) - The European Commission unveiled sweeping plans for the European Central Bank to supervise all euro zone banks on Wednesday, though Germany immediately raised objections that the proposals risked overstretching the ECB.
European Commission President Jose Manuel Barroso set out the proposals in a speech to the European Parliament, telling its members that giving the ECB responsibility for monitoring banks would be the first step towards creating a banking union for Europe.
The reforms, which need to be approved by the European Union's 27 member states, aim to break the link between struggling banks and heavily indebted governments, an interdependence that has exacerbated the debt crisis over the past three years.
By empowering the ECB to police all banks in the euro zone, the proposal hopes to break the vicious cycle and then lay the ground for deeper fiscal cooperation across the EU as the economic and monetary underpinnings of the union are strengthened.
"We need to move to common supervisory decisions, namely within the euro area," Barroso said in his speech, saying the ECB should take charge of all euro zone banks - by most estimates around 6,000 institutions.
Germany, which is keen to retain primary oversight for its regional savings and cooperative banks, had already questioned whether the ECB should spread itself so thinly and repeated its reservations immediately after Barroso's speech.
Both Chancellor Angela Merkel and Finance Minister Wolfgang Schaeuble said the ECB would be more effective in its oversight if it had responsibility only for the largest, systemically important banks in the euro zone, which number about 25-30.
"The quality and efficiency of the new supervisor must be the focus. Purely on practical terms it seems impossible for the ECB to monitor 6,000 banks appropriately," Schaeuble said in a statement.
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.
For the plan to work, however, it will require countries to surrender a degree of sovereignty over banking supervision, which has long been a national responsibility. Both Germany and Britain have chafed at the surrender of oversight, for different reasons. Some eastern European states are also concerned.
Given that day-to-day supervision of banks would remain the task of national regulators, some officials suspect that Berlin's real concern is that a banking union would see it paying the costs of propping up lenders in weak countries.
Georg Fahrenschon, the President of the influential German Savings Banks Association, said domestic savers could be hurt by the Brussels blueprint.
"At its core, the proposal means that what is saved for the security of savings and cooperative bank customers could be used in the event of problems at European banks," he said. "The level of protection of German savers would be reduced."
Investors are following developments closely, as handing powers of supervision to the ECB unlocks the possibility of direct aid to banks in Spain, for example, from the euro zone's permanent rescue scheme, the European Stability Mechanism, which was given the go-ahead by Germany's Constitutional Court earlier on Wednesday.
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.
Disagreement would delay the introduction of the new regime beyond the target set by euro zone leaders of the beginning of next year.
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.
IN OR OUT
The ECB welcomed Wednesday's proposal, saying it laid the foundation of a financial market union to ensure financial stability in the euro zone.
Under the plan, the ECB would be at the head of the currently fragmented system of national regulators, with the power to police, penalise and even close banks.
It would also gain powers to monitor banks' liquidity and demand they hold more capital to protect themselves against future losses.
London is also apprehensive. 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 suggested 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.