08/01/2012 06:27 am ET Updated Oct 01, 2012

European Central Bank's Watchdog May Get Power To Force Bank Closures

* Officials to finalise plan for uber-watchdog by September

* Supervisor to have wide remit to police banks in euro zone

* Officials consider moving watchdog away from Frankfurt

By John O'Donnell and Marc Jones

BRUSSELS/LONDON, Aug 1 (Reuters) - The European Central Bank's watchdog for banks could get the power to order the closure of lenders in what would be a radical step to tackle the crisis, prompting concerns by policymakers that such responsibility could backfire.

The plan remains subject to intense debate between the ECB, the European Commission and member states, but officials and policymakers who spoke to Reuters have outlined a framework of how an ECB-sponsored uber-watchdog could work.

Speaking on condition of anonymity, they said the latest plans envisage giving the euro zone's central bank the remit to police far more than just the currency area's 25 top banks, as originally expected.

It is also likely to be allowed step in above national regulators wherever it identifies problems at a smaller lender.

"If you have something for 25 banks, you do not address the issue," said one EU official.

"None of the problems we had in the past related to the top 25 banks. The scope should be all banks. The smaller the bank, the more decisions will take place at a local level."

The blueprint, which is due to be finalised by the EU's executive in the coming weeks and announced in September, is central to building a banking union, forging a unified front among euro zone countries in tackling a five-year bank crisis.

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 if and when countries would benefit.

The regulating agency, which will be set up under the wing of the ECB, may also be located away from Frankfurt - a choice that divides opinion among countries and officials. The ECB declined to comment.

Moving it away from Germany's financial capital, home to the ECB, could help win broad backing from countries to hand it to control banks around the euro zone.

Such a step could also address some of the ECB's own anxiety about taking on the new supervisory role, which some officials concerned about the central bank ending up in a position where it takes decisions with an impact on national budgets.

Some central bankers are worried that should the ECB get too much responsibility for supervising banks, this may prove unmanageable and backfire later, hurting its image if it fails to spot problems and take action.

One solution to this would be to separate the resolution authority, responsible for winding up troubled banks, from the supervisor. Some central bankers would like to see any winding down of banks carried out under the umbrella of the ESM.

Locating the agency away from the central bank would also allow for what one official described as an "arms length" relationship between the agency and the ECB.

ECB President Mario Draghi has said he will not allow "contamination" of the bank's primary role by supervision work.

"Any new tasks in terms of supervision should be strictly separate from monetary policy tasks," Draghi said recently. "There should be no contamination between the two areas and we will certainly find ways to make it sure that this is the case."

His comments reflect discomfort among some of the bank's policymakers about taking on supervision responsibility, concerns that one euro zone central bank source summarised.

"What would happen if another bank in Spain went down under the ECB's watch?"

Officials will also attempt to find agreement on giving the new bank supervisor, the power to close failing lenders.

This is likely to prove one of the most contentious points with countries, who would directly deal with the fallout including having to pay for at least some of the costs of such closures.

"The right to withdraw the banking license, which is the hour of death for the bank, must be with the supervisor," said one EU official with knowledge of the plans. "If the ECB becomes the supervisor, it has to have this (power)."

"Withdrawing the banking license is a key issue. If a bank is not viable, it should be closed. If you don't do that you are going to have a lot of zombie banks. There is no clarity about which are the viable ones that have a future."

That view was echoed elsewhere. "If a banking union is complete, you also have a bank resolution authority," said a second EU official. "The aim would be to have a twin authority - resolution and supervision."

A European Commission spokesman said: "More integrated bank resolution and deposit guarantee systems are essential parts of the banking union. This work will be taken forward building on existing and future Commission proposals."

One central bank official said the ECB's new agency should be able to give the order to close a struggling bank or demand its break-up.

An advisory committee to the European Systemic Risk Board, a group chaired by Draghi that identifies economic threats, called this week for the creation of a European Resolution Authority to wind down weak banks.

Some policymakers at the ECB are worried that taking on such a task could entangle it in messy closures and are pushing for this role to be limited to ordering the closure of banks, leaving their actual liquidation to another agency. (Writing by John O'Donnell)