Germany and France were split ahead of crucial talks on Sunday over how to strengthen shaky European banks and fight financial market contagion to prepare for a possible Greek default.

Under strong U.S. and market pressure Chancellor Angela Merkel and President Nicolas Sarkozy will try to bridge differences on how to use the euro zone's financial firepower to counter a sovereign debt crisis that threatens the global economic recovery.

A ratings downgrade on both Italy and Spain by Fitch Ratings on Friday underscored the grim climate.

A German source said Paris wanted to be able to tap the euro zone's 440 billion euro rescue fund to recapitalize its own banks, which have the largest exposure to peripheral euro zone debt, while Berlin insisted the fund should be used only as a last resort when no national funds are available.

After meeting Dutch premier Mark Rutte, Merkel confirmed the German position was that the European Financial Stability Facility was a backstop to be used only if that country is unable to cope on its own.

A French Treasury source told Reuters that Paris believed banks unable to raise capital on the open market should be able to tap the fund, but talk of divergences with Berlin was premature since the issue had not yet been debated.

Merkel said struggling banks should look first to the markets, then their national government, and only in the last instance the EFSF, and with reforms as a strict condition.

This will definitely be discussed at the next summit, she said, referring to an EU leaders meeting on October 17 and 18 for which she and Sarkozy will attempt to set the agenda.

The French government and the Bank of France had dismissed until this week any need to recapitalize French banks and are now wrangling over how to do it in a way that does not put the country's top-notch credit rating at risk.

I hear that the French are scared that too much bank recapitalization could jeopardize the French AAA and that is why they push for the EFSF solution for French banks. I expect Merkel to stick to national funds for recapitalization, said economist Jacques Delpla, a member of the French government's advisory council of economic analysis.

France has the highest debt-to-GDP ratio of any of the six triple-A countries in the euro zone at 86.2 percent.

If France, the second largest guarantor of the rescue fund after Germany, were to lose its top-notch rating, the whole edifice of financial support for Greece, Portugal and Ireland would crumble.

DEXIA SQUABBLE

A senior European diplomat said that because of its exposure and concern for its credit rating, France was more hesitant than Germany or Britain about the need to restructure Greece's debts and take losses as soon as possible.

Preserving France's AAA status was politically sensitive seven months before a presidential election in which Sarkozy is trailing the opposition Socialists in opinion polls, he said.

Many major European banks continue to insist they need no more capital, although the International Monetary Fund says up to 200 billion euros must be injected.

The chief executive of Societe Generale , Frederic Oudea, told Reuters Insider TV the main problem was not one of capital but liquidity as interbank lending dries up.

The main issue is a crisis of confidence in the sovereign. ... What is important is to deal with the Greek issue as quickly as possible and then rebuild confidence in the capacity of each bank in Europe to reduce its debt, Oudea said at SocGen's Paris headquarters.

Some banks are clearly in need, however.

France and Belgium are arguing over whose taxpayers should pay to salvage cross-border municipal lender Dexia, which came close to collapse this week and is to be broken up.

Moody's Investor Service on Friday said it may cut Belgium's credit rating.

U.S. President Barack Obama implored European leaders on Thursday to come up with a plan before a Group of 20 major economies summit in Cannes, France, on November 3-4, saying the euro zone crisis was the biggest cloud over the U.S. economy.

Bank of Japan Governor Masaaki Shirakawa said on Friday that the European sovereign debt woes were putting Japan's economy under growing strain.

Shirakawa told a news conference in Tokyo that global growth is slowing as a trend and European growth was stalling as debt worries mount.

European Commission President Jose Manuel Barroso said on Thursday the EU's executive arm was preparing a plan for bank recapitalization across the 27-nation bloc.

However, other EU officials have made clear it would only be a set of guidelines for national measures and an approach for cross-border banks, and not a common European mechanism or mandatory rules on recapitalization.

The European Banking Authority, which coordinates national regulators, is reassessing banks' capital buffers based on data provided for stress tests conducted in July, which showed that only eight banks failed, requiring just 2.5 billion euros in extra capital.

A euro zone supervisory source said a figure of 180-200 billion euros cited by International Monetary Fund and private economists reflected the impact of writing down sovereign bond holdings to current low market prices and assuming that Greece and perhaps another country would default.

DEFAULT POSSIBLE?

Both Merkel and Sarkozy have reaffirmed in the last week that a Greek default must be avoided because it would have potentially catastrophic consequences for the European and global economy.

The French Treasury source said Paris was open to modifying some elements of a July 21 agreement by euro zone leaders to make private bondholders share the cost of a second bailout for Greece, such as debt maturities and interest rates, but a full-scale rewrite was undesirable.

German and Finnish officials argue that since market conditions have changed, banks may need to take more than the agreed 21 percent write-down on their Greek holdings.

A team of EU and IMF inspectors is continuing negotiations with Greece on reforms required to release a vital 8 billion euro aid installment by mid-November.

Fitch late Friday cut Italy's sovereign credit rating by one notch and Spain's by two, citing a worsening of the euro zone debt crisis and a risk of fiscal slippage in both states.

The downgrades knocked the wind out of the euro, which slipped 0.3 percent to $1.3388, leaving it rooted in a downtrend that began at $1.4548 on August 29.

Italy's rating fell to A-plus from AA-minus, and Spain's was lowered to AA-minus from AA-plus. Both countries, respectively the third and fourth largest economies in the euro zone, were placed on a negative outlook suggesting further downgrades could come in future.

(Additional reporting by Jean-Baptiste Vey and Catherine Bremer in Paris, Paul Carrel in Berlin, Philipp Halstrick in Frankfurt, Julien Toyer in Brussels,; Writing by Paul Taylor/Mike Peacock/Glenn Somerville)

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