FRANKFURT (Reuters) - Italy’s multi-billion-euro closure of two lenders drew sharp criticism on Monday for hurting a project devised to underpin confidence in the euro zone during the financial crash.

A Banca Popolare di Vicenza sign is seen in Rome, Italy, March 29, 2017. REUTERS/Alessandro Bianchi

As lawmakers digested details of the rescue, which involves the state rather than investors bearing most of the cost, many criticized Rome for breaking with the spirit of a framework known as banking union -- and the European Commission in Brussels for allowing it do so.

Under a deal sealed over the weekend, Italy will pay more than 5 billion euros to Intesa Sanpaolo ISP.MI, its top retail bank, to take the best assets of two failed Veneto banks, with up to 12 billion euros of guarantees to shield Intesa from losses.

That broke a principle agreed by European leaders and enshrined in European Union law that investors, rather than the state, should shoulder the cost of bank failures.

“It was all for nothing,” said Philippe Lamberts, a Belgian Green party member of the European Parliament who spent months negotiating and writing the law introduced last year.

“This is a bad day for Europe. It’s another hit to European integration,” he said, describing it as a “major blow” to the euro currency itself and damaging for the image of the European Central Bank, which supervises Europe’s biggest lenders.

Sven Giegold, an EU parliamentarian who also helped write the law, demanded a parliamentary enquiry into the flouting of the rules, attacking the Commission, the EU’s executive. It had the final say in approving the scheme.

Investors breathed a sigh of relief following the decision, with shares rallying, while Italy sought to portray the move in a positive light.

It removes one of the chief financial headaches facing the country. One Bank of Italy official even said that the state could eventually make a profit from the deal.

But European lawmakers struck a more somber tone.

FROSTY RECEPTION

Markus Ferber, a German lawmaker in the European parliament, said Italy had not respected the new rules and predicted that Germany would be reluctant to pursue closer ties in the 19-member euro zone as a result.

“This is bringing banking union to the graveyard,” said Ferber, a member of Bavaria’s Christian Democrats, the sister party of German Chancellor Angela Merkel’s ruling conservatives.

“It makes no sense to have further integration,” he said, citing the example of pan-European protection of deposits, the next step that had been planned for the banking union. “No-one could seriously grant Italy access to deposit protection.”

Germany, worried that it would have to shoulder the bill for failed banks in countries such as Greece or Spain, had been central in writing the rules to force losses on the bondholders and large depositors of failing banks.

Germany’s finance ministry also gave the Italian announcement a frosty reception.

“The use of state aid should be avoided as much as possible in bankruptcy cases,” a spokeswoman for finance minister Wolfgang Schaeuble said, adding that it was up to the European Commission to ensure that the rules were respected.

Rome had hoped healthier Italian banks would club together to help the lenders, Banca Popolare di Vicenza and Veneto Banca. But most would not, having already spent billions propping up other ailing banks.

Italy’s subsequent move to sidestep the EU regime now raises a question mark over the entire framework and whether it can ever be used instead of taxpayer bailouts.

The events also cast a cloud over the ECB, which monitored the banks and had deemed them solvent until recently. It declined to comment.

That Italian solution contrasts with Santander's SAN.MC recent rescue of a struggling lender in Spain, where it too paid just 1 euro but took on the smaller bank's troubled loans and imposed losses on shareholders, including retail investors.

Alberto Ruiz Ojeda, a lawyer from the Spanish Association of Minority Shareholders who is representing Banco Popular investors taking action after the rescue, said the move by Italy would encourage more of those who lost money to sue.

“Intesa Sanpaolo is going to benefit from a scheme that Banco Santander has not been able to,” he said. “What we see is discriminatory and unfair treatment. This will give rise to more claims, both from Popular shareholders and bondholders.”

While German politicians were among the most vocal critics, lawmakers from other countries also expressed dismay.

Greece’s banks received more robust treatment and the capital controls introduced to stabilize the country’s feebler banks and financial system are still in place.

“It is not a fair world. It is obvious that Italy is quite another country to Greece,” said Kostas Chrysogonos, a European lawmaker with Greece’s left-wing Syriza party, recalling the strict terms imposed on Athens.

“What you have is more a cooperation of states and not an authentic union.”