BRUSSELS (Reuters) - EU states are moving ahead with talks on whether to limit the amount of sovereign debt banks can hold, despite some countries’ fears that the policy could upset bond markets and banks’ financial stability.

In a document drawn up as the basis for discussion by government officials in Brussels on Tuesday, the Dutch presidency of the European Union says the bloc may need to regulate banks’ sovereign holdings before decisions are taken at a global level.

EU sovereign bonds are currently treated as risk-free and are exempt from exposure limits like those imposed on banks’ holdings of corporate or household debt.

Germany says limiting exposure to sovereigns would strengthen banks’ balance sheets, reducing the risk to taxpayers in any future system where EU states share the cost of rescuing failed banks.

Italy, whose banks hold large amounts of Italian national debt and may see the value of their holdings slashed if limits were imposed, is among the countries opposing the move.

With Germany, the bloc’s biggest economy, pushing for the policy, it has been included in talks to complete a banking union, the flagship EU project to improve financial stability.

“A number of member states expressed the need for amending the regulatory treatment of sovereign exposures for the banking union, considering the enhanced level of cross-border spillovers and risk sharing that is inherent to the banking union and its institutional setup,” the Dutch paper said.

The European Commission, the EU executive, had wanted to wait for decisions at global level by the Basel Committee, a body of banking supervisors from nearly 30 countries, but the Dutch paper said EU states should push ahead.

“Considering that discussions in the Basel Committee are focused on the risks perceived globally while the outcome of its work is yet uncertain, political guidance is warranted on whether and how to ensure an adequate regulatory treatment,” the Dutch paper said including the topic in a list of areas “where further measures might be warranted”.

EDIS HITS NEW SNAG

The document also opens discussions on whether EU governments should be able to veto the creation of a European Deposit Insurance Scheme (EDIS), considered a pillar of the banking union, a move likely to delay the project.

Again, Germany is cautious, fearing it may pay a disproportionate cost to rescue any banks that fail in other EU countries, and wants EDIS to be agreed on a consensus basis, rather than letting the majority decide.

The Dutch paper said officials should discuss whether EDIS should be decided as “an Intergovernmental Agreement,” something that would require the consent of all member states.

A similar procedure was used to set up a single resolution mechanism to wind up failing banks. The Commission warned against using this procedure again as it took nearly two years for the deal to be ratified.

In case of a major banking crisis, some euro zone states may currently not be able to protect all insured deposits without EDIS in place. EU rules demands that states guarantee bank deposits up to 100,000 euros ($113,770).

The Dutch paper also said that talks on a backstop for the newly established bank resolution fund should start in June.

The backstop, likely to be provided by the euro zone bailout fund, the European Stability Mechanism, would make sure that banks were effectively rescued with bank money and not through taxpayers-funded bailouts, another policy opposed by Germany.