Blunt Dutchman casts doubt on Europe's bank promise

* Germans, Dutch, Finns reluctant to use euro fund for banks

* Ireland, Malta and Luxembourg distance themselves from Cyprus

By John O'Donnell

BRUSSELS, March 27 Blunt remarks by a leading minister saying European support for troubled banks is a last resort laid bare what has long been an open secret in Brussels: promises to create a euro zone backstop for banks may never be fulfilled.

Designed to secure a level playing field in the euro zone and prevent vulnerable countries having to contain financial problems alone, a European banking union was one of the biggest political commitments made to underpin the euro.

Comments from the head of the Eurogroup of finance ministers this week that countries which encounter bank problems may have to cope alone, however, underscore resistance to delivering on last year's promise.

"Strengthen your banks, fix your balance sheets and realise that if a bank gets in trouble, the response will no longer automatically be that we'll come and take away your problem," Jeroen Dijsselbloem told Reuters.

"We're going to push them back," the Dutch Finance Minister said shortly after announcing a bailout of Cyprus that forced the closure of the country's second-biggest bank and imposed huge losses on big depositors.

"That's the first response we need. Push them back. You deal with them."

His candid remarks, described by one EU official as "not the most brilliant thing to say", clashed with a commitment by euro zone leaders to club together when banks fail. They irritated many in Brussels, used to gentler diplomacy.

The comments also grated in Dublin, which still hopes the euro zone will stand by a pledge to allow its rescue fund, the European Stability Mechanism, to recapitalise banks directly.

Bailed out by European countries and expected to resume normal borrowing on markets this year, Ireland wants direct assistance available for its banks should they get in trouble again to avoid the risk of adding to the country's debt.

It is also hoping the ESM will assume some of the burden of big recapitalisations that have already taken place.

"The principle which was agreed in June was to break the link between sovereigns and banks and the clear understanding... is that the ESM ... of course will potentially be used for recapitalisations," Ireland's European Affairs Minister Lucinda Creighton told Reuters. "That's the whole point."

The euro zone's three main triple-A rated states, Germany, the Netherlands and Finland, said last year the ESM could only be used if trouble arose at banks under European supervision in future, leaving "legacy" problems to home countries.

Dijsselbloem appeared to go further when he said the aim should be "a situation where we will never need to even consider direct recapitalisation".

After remonstrations from several euro zone partners, he issued a statement clarifying that Cyprus was not a template but a special case.

Another euro zone source said the Dutchman, barely one month in the job, had got carried away by his enthusiasm and needed to learn that, as head of the Eurogroup, "you must give up on expressing personal opinions".

Small countries like Ireland have every reason to be concerned. The closure of banks in Cyprus and the imposition of controls on money movements once they reopen may achieve exactly the opposite effect of a banking union.

Capital controls are a step backwards from the integrated financial market with a single supervisor and resolution mechanism, designed to underpin confidence in banks no matter where they are based.

"They have solved the problem in Cyprus temporarily, at the cost of a higher probability of future bank runs," said Paul De Grauwe of the London School of Economics. That followed the decision to hand losses to some big depositors, sparing those with less than 100,000 euros, who are protected under EU law.

"The signal has been given very clearly. If a country like Ireland gets into trouble, deposit holders will pay. That makes banks in Ireland more fragile," De Grauwe said.

Further complicating the picture for small countries such as Ireland is the size of its financial sector.

Three countries in the euro zone have a banking sector which is similarly overblown to that of Cyprus, according to statistics from the European Central Bank.

While the Cypriot bank system, as measured by assets, was seven times the size of its economy, Ireland's is similarly overgrown. A spokesman for Ireland's department of finance said, however, that roughly 70 percent of the country's banking sector was made up of internationally-owned banks and other groups such as investment funds, rather than domestic banks.

Malta's banking sector is equivalent to roughly eight times its economy, but its central bank governor told Reuters that comparisons with Cyprus were misleading.

Luxembourg has a banking system 22 times its GDP, compared with Germany and Finland at around three times. Deposits there are equivalent to about 10 times the tiny country's economy.

Host to about 140 subsidiaries of banks and insurers, the Grand Duchy has made a name for itself as a financial centre, making its fewer than 500,000 citizens Europe's wealthiest.

The Luxembourg government said it opposed the kind of capital controls that Cyprus is readying. It rejected any comparison with Cyprus, saying the yardstick of economic output compared with the size of its financial sector was simplistic.

For Guntram Wolff of think tank Bruegel, however, the danger is clear. "When you have a large banking system you are at a higher risk," he said. "Self-fulfilling market panic can happen in a country with a large financial system."

Dijsselbloem's comments and the radical shake-up in Cyprus have sent a chill through the Mediterranean island of Malta, the euro zone's smallest country and one of its most isolated.

"This is not just a Cyprus problem. It's a fundamental problem of the euro," said Joseph Falzon, an economist at the University of Malta.

"Is it going to be every country on its own? Is the euro going to be destroyed? From a small island, it's worrying. At the end of the day, it's still an island. The only thing we have is our savings and investments."

But with the debt of fragile euro zone banks of almost 5 trillion euros and weaker governments in no position to support them further, some investors believe Dijsselbloem has done little more than state the obvious, namely that bondholders or savers rather than governments must shoulder some of the burden.

"He's being more honest than most policymakers," said Eric Stein, a fund manager with Eaton Vance Investment Managers, a U.S. investor that buys European government debt. "This honesty is a step in the right direction."