German lender Commerzbank and the government have been in talks for several days over possible state aid, five people familiar with the matter told Reuters on Monday.

The aim was to reach an agreement in principle by Christmas, coalition sources said on Monday.

While Commerzbank, 25 percent-owned by Germany, wants to avoid state aid, it needs to find 5.3 billion euros ($7 billion) capital by mid-2012 to meet European Banking Authority capital rules.

Since Germany's second-largest bank raised 5.3 billion euros from shareholders in June, writedowns on Greek sovereign debt and tougher capital rules have eroded its capital cushion.

How Germany could help strengthen Commerzbank's balance sheet remains open, coalition and banking sources said.

On Monday, Commerzbank stood by its commitment to avoid taking more help from Germany, which would move it nearer to nationalization -- a spokesman reiterated its stance last Thursday when chief financial officer Eric Strutz said: We stand by our intention not to make use of additional public funds.

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GRAPHIC-Euro banks CDS price: http://link.reuters.com/qux33s

GRAPHIC-Bank deleveraging: http://r.reuters.com/bag45s

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In particular, the bank wants to avoid a direct capital injection and would rather bolster its balance sheet by shedding liabilities, people close to Commerzbank said.

One option is transferring parts or the whole of its problematic Eurohypo unit to a bad bank within Germany's bank rescue fund SoFFin, these people said. By unloading the risky assets from its loss-making real estate finance unit to the government rescue fund, Commerzbank could free up 5 billion euros.

Germany is already preparing legal work to reinstate the SoFFin bank rescue fund.

German ruling coalition sources said the question of whether Commerzbank could be forcibly recapitalized remained open.

Commerzbank received an 18.2 billion euros bailout in 2008, and had repaid around 14.3 billion by this summer.

Its core tier one capital ratio was 9.4 percent at the end of the third quarter, although its definition differs from that of the EBA, which has demanded banks meet a core tier one ratio of 9 percent by mid-2012 in a bid to shock-proof them against a worsening of the financial crisis.

The EBA's capital definition is more stringent because it asks banks to revalue European sovereign debt holdings on their portfolios.

At the end of September, Commerzbank had 13 billion euros exposure to the sovereign debt of Greece, Ireland, Italy, Portugal and Spain.

Banks need to inform regulators by January 20 how they will plug gaps in their balance sheet to achieve a core Tier 1 capital ratio of 9 percent by mid-2012, as required by the EBA.

In October, Commerzbank chief executive Martin Blessing said it would not tap state rescue fund SoFFin a second time.

($1 = 0.7567 euro)

(Reporting by Kathrin Jones, Alexander Huebner, Philipp Halstrick, Edward Taylor; Editing by David Hulmes and Dan Lalor)

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