Seeking to break the link between weak banks and debt-laden sovereigns that threatened to undermine the euro, European Union leaders agreed in June 2012 to forge a banking union — with a single rule book on banking supervision, resolution and deposit insurance — to buttress the industry.

Today that union is taking shape on a far smaller scale and much slower timetable, reflecting deep skepticism in Germany about opening the nation’s purse wider for bailouts. The tepid progress leaves the euro area and its banks vulnerable to stresses if global interest rates start to rise, analysts warn.

At a summit meeting in Brussels at the end of June, EU leaders set a year-end deadline for adopting a directive to establish a mechanism for resolving failing banks and require member states to set up resolutionrestored “resolution” funds to cover the costs of intervention.

Left unsaid is the nature of the resolution mechanism. The European Central Bank, which will take over the responsibility for supervising major banks from national authorities next year, wants a single EU body with the power to resolve banks. On July 10, the European Commission endorsed a proposal, drafted by Economic and Monetary Affairs commissioner Olli Rehn, for the creation of a Single Resolution Mechanism involving the ECB, the Commission and members of national authorities. Crucially, the new arrangement would give the Commission, the EU’s Brussels-based executive agency, the power to decide whether and when to resolve a bank.

But German Chancellor Angela Merkel, reluctant to give more power to EU bodies ahead of parliamentary elections in her country in September, is resisting the push. Shortly before the June summit she issued a joint paper with French President François Hollande proposing that any bank resolutions be handled by a network of national authorities. In Berlin, the idea of giving an EU agency the power to call for the closure and resolution a German bank in the future is politically unacceptable. Few European officials expect the German government to give ground on this point after the elections, whether Merkel retains power or not. For most EU officials, however, the idea of relying on swift and effective coordination among national authorities during a crisis is a recipe for disaster.

“The system is not stable,” says one senior EU official. “It will only be stable when we have a single resolution mechanism.”

The split sets up a major battle between Germany, the linchpin of the euro area, and most of its partners and EU institutions. It also raises the stakes for an asset quality review that the ECB will conduct on EU banks early next year before it takes over as lead supervisor. The review “will produce a demand for capital in the next years,” says Graham Bishop, an independent U.K. economist and a frequent adviser to EU bodies on euro issues. Some market estimates put the need for capital among euro area banks in the range of €150 billion to €200 billion ($195 billion to $260 billion).

Current banking union plans won’t break the vicious circle between weak banks and weak sovereigns, and they leave the euro dependent on the promise of ECB support, says Laurence Boone, Europe economist at Bank of America Merrill Lynch in London.

“What it means is that fundamentally you’re not solving the problem,” she says. “It’s a bit worrying that things are not moving forward very quickly, and it’s a bit worrying that the environment is becoming less benign.”