By Andreas Rinke and Matthias Sobolewski
BERLIN (Reuters) - Angela Merkel's conservatives and the Social Democrats (SPD) have struck a deal on the contours of a European banking union under which a body attached to European finance ministers, not the European Commission, would decide when to close failing banks.
Several sources involved in coalition talks between the parties told Reuters the two camps had also agreed funds from the European Stability Mechanism (ESM) should not be directly available for winding down financial institutions.
The sources said a number of legal questions needed to be resolved but the goal is to sign off on the agreement early next week so Finance Minister Wolfgang Schaeuble can go to a meeting with his EU colleagues on Thursday with a firm German position on the issue.
The EU wants to agree a deal on bank resolution by year end but uncertainty over Berlin's stance after September's election that led to complex coalition talks has sowed doubts about whether it can meet the deadline.
"The talks on this issue are going full steam ahead. Both parties are still far from an agreement on the questions of procedure and content," SPD spokesman Benjamin Seifert said.
In Brussels, a spokeswoman for Michel Barnier, the European commissioner responsible for the banking union reform, said he was open to the idea that the agency for the closure of failed banks would not be linked to the Commission.
After the ECB's demand on Friday for a single fund to pay for the cost of bank failures, she said this was important for the "credibility of the overall system".
The so-called Single Resolution Mechanism (SRM) is a pillar of a broader banking union that aims to break the "doom loop" between failing banks and sovereign governments - a major problem for the euro zone during its debt crisis.
The compromise stems from a meeting on Thursday between Schaeuble, his party colleague Herbert Reul and SPD politicians Peer Steinbrueck, Martin Schulz and Olaf Scholz.
It satisfies an SPD demand that the ESM not be used to wind down banks while addressing concerns in Merkel's conservative camp about giving the European Commission resolution powers.
The sources said until a common resolution fund, to be financed by the banks, had built up sufficient liquidity, national states would have to shoulder the burden of winding down their own banks. Should states run into financial problems, they could turn to the ESM for aid, as Spain has done.
The creation of a special body attached to the Ecofin council, the group of 28 EU finance ministers that meet monthly, would address Schaeuble's concerns about the democratic legitimacy of ceding resolution powers to the Commission.
A simple majority of Ecofin states would be able to decide on the winding down of a bank under the plan, the sources said.
EU ministers will meet in Brussels to discuss building the second pillar of banking union, the scheme to close or salvage troubled banks. Settling those issues is necessary before the euro zone can complete one of the biggest projects since the start of the single currency.
The banking union would both police banks and find joint solutions to their problems.
Creating a body attached to Ecofin rather than the Commission would raise the problem of a legal basis for the single resolution authority.
The Commission has proposed itself as the resolution body because that was the only way to avoid changing the EU treaty - a lengthy and risky process. Attaching the SRM to the Ecofin council would either require a change to the EU treaty or creating a separate intergovernmental treaty like the one on which the bailout fund is based.
Excluding the ESM from financing closing down banks will raise the problem of a financial backstop for the SRM, possibly delaying its proper operation for years - for as long as resolution financing remains in the hands of national governments.
Five years after the financial crisis erupted, many European banks remain in trouble, holding back the euro zone economy as it gradually recovers from recession.
Behind Germany's demands are two chief concerns. Berlin does not want to be told by Brussels to close a German lender. Neither does it want to be left on the hook for the clean-up of bank crashes elsewhere.
The wishes of Germany, Europe's biggest economy which has shouldered much of the cost of bailing out countries from Greece to Ireland, cannot be ignored. But Berlin can count on few allies for wholehearted support for its tough stance.
While Finland backs it, most countries, including France, Spain, Italy, Portugal and Belgium, are seeking to soften Germany's stance. They hold out hope that it will allow a single European fund to mop up individual bank problems.
(Reporting by Andreas Rinke and Matthias Sobolewski in Berlin, Jan Strupczewski and John O'Donnell in Brussels; Writing by Noah Barkin; Editing by Erik Kirschbaum and Janet Lawrence)