LIMOSSOL, Cyprus (Reuters) - European Central Bank policymaker Panicos Demetriades said on Tuesday that an EU plan to set up a single supervisory mechanism for euro area banks by the end of 2012 was ambitious, but feasible.
"In my view, every effort should be made to move ahead as quickly as possible based on a phasing-in approach," Demetriades, who is also governor of the Central Bank of Cyprus, told a business audience.
He said the supervision scheme was urgently needed because it was a precondition for the possible direct recapitalization of banks by the European Stability Mechanism, the EU's permanent bailout fund.
Plans for a European Banking Union - the single supervisory mechanism being one component of the broader framework along with European deposit insurance and resolution schemes - would partly address the current financial crisis by helping to sever the link between sovereigns and banks, he said.
The EU is aiming for the bones of a banking union to be in place early in 2013.
"For countries like Cyprus with large banking systems, the banking union is particularly important since it will decouple sovereign risk from banking risk," Demetriades said in a prepared text.
Cyprus sought financial support from its EU partners and the IMF in June after its two largest banks sought state assistance due to their heavy exposure to the restructure of Greek debt.
Consultations with lenders have been inconclusive but Demetriades reiterated previous comments that he expected a successful conclusion by the end of next month.
"Our aim, as the central bank, is to bring the talks to a successful conclusion by the end of October 2012," he said.
Recapitalization was also an opportunity to review and restructure the island's banking system, he said.
Demetriades, a financial academic who became central bank chief in May, has long argued that Cypriot banks over-extended themselves.
The island's domestic banking sector is worth about 5.5 times Cyprus's GDP, or 8 times GDP if foreign banks based on the island are included.
More emphasis should be placed on strengthening corporate governance, risk assessment and policies to strengthen the resilience of the system, he said.
In the next few years he said he expected the overall size of the Cypriot banking system to shrink relative to the size of the economy.
"We need our banks to focus on core business, which may involve, among other things, withdrawing from some retail operations overseas while ... improving services to international clients on the island," he said.
Writing By Michele Kambas; Editing by Susan Fenton