By Tony Connelly, Europe Editor, Brussels

When back in June eurozone leaders hatched a deal on bank debt in the early hours of the morning during a summit in Brussels, the Taoiseach Enda Kenny described it as a “seismic shift”.

The breakthrough that would lift the burden of Ireland’s appalling bank debt would off the taxpayers’ shoulders had finally arrived.

The statement that emerged from the all-night meeting declared that eurozone finance ministers would “examine the situation of the Irish financial sector with the view of further improving the sustainability of the well-performing adjustment programme.”

That was taken to mean that lifting the bank debt from the sovereign would indeed further improve the sustainability of Ireland’s bailout, and by a logical extension, enhance the country’s return to the markets.

The prospect of a deal seemed to be nailed by the sentence which came after: “Similar cases will be treated equally.”

That referred to a preceding reference to the ESM, Europe’s €500 billion permanent fund, being allowed to directly recapitalise banks in such a way as to avoid the burden going on to the state’s books.

Back in June the burning issue was Spain, whose banks were suffering the horrendous blow-back from the property bubble. That night the Spanish prime minister Mariano Rajoy and his Italian counterpart Mario Monti appeared to ambush the German Chancellor Angela Merkel into conceding a major principle: the use of the ESM to directly recapitalise banks.

What was good for Spain, therefore, was good for Ireland. Hence similar cases being “treated equally.”

While the 29 June statement didn’t set out deadlines or mention the word “legacy” in relation to bank debt, its spirit was well understood by the Irish government and others – France, Spain and Italy – that the ESM would be able to directly recapitalise Irish banks.

That would lead to relief for the Irish taxpayer.

The key phrase in the summit declaration was its opening line. “It is imperative to break the vicious circle between banks and sovereigns.”

The vicious circle had only been caused by problems that banks had already sustained, so it stood to reason that the only way to break it was for the ESM to assume debts that had been run up in the past, in other words, “legacy” debt.

That has been the belief of the Irish government, and, indeed, the European Commission.

The question of the €28 billion Anglo promissory notes were a separate issue that would be dealt with bilaterally between the Irish government and the ECB. Irish officials hoped, however, that the logic of breaking the vicious circle between banks and sovereigns would eventually extend to the Anglo issue.

That the coalition should claim victory appeared reasonable, despite mutterings from the opposition. It was there in black and white.

Or so it appeared.

A few weeks later in July finance ministers started work on the issue. Olli Rehn even said he hoped that the Irish bank debt issue could be concluded by the end of this month.

Now as EU leaders gather for their first full summit since the summer that idea is out of the question.

What has gone wrong?

As is so often the case, all explanations lead to Berlin. There were howls of protest in the German media at the outcome of the June summit. That the ESM, which would be stuffed largely with German taxpayers money, should become such an easy resource for profligate governments was too much.

Almost immediately Wolfgang Schauble, the finance minister, began to cast doubt on the immediacy and scope of the deal.

Any doubts that Germany wanted to drag the issue into the sand were dispelled when Schauble joined his counterparts from Finland and the Netherlands in Helsinki on 25 September.

A statement issued afterwards declared that the ESM could only deal with problems that arise under the new regime. Therefore the problem with “legacy assets” had to be dealt with by national authorities.

Dublin was quick to dismiss the statement as just one of a number of ideas that were feeding into the process. A clarification from the Hague that the ESM couldn’t recapitalise banks that were “not viable” reassured the Department of Finance that Irish banks – with the exception of Anglo – were in the clear.

When the Taoiseach and half the cabinet came to Brussels on 3 October on pre-presidency business there were further words of support from the Commission president Jose Manuel Barroso and European Council president Herman Van Rompuy.

So what is Berlin’s problem?

The answer lies in Merkel’s shaky political strength at home and the federal elections due in September next year.

Any immediate drain on the ESM’s resources will have to be approved by the Bundestag. If Ireland’s banks were to join the queue of Spanish banks, another lifeline to Greece, and a potential bailout for Cyprus, then that would present a major political headache for Merkel heading into election year.

Already she’s facing opposition from her coalition partners the FDP, and from the CDU’s sister party the CSU.

Angela Merkel has never explicitly sided with Wolfgang Schauble on the legacy debt issue (she may be tackled on this at the summit).

But her officials are reported to have come out with a hardline posture that Ireland foolishly raised expectations on legacy debt, and that since the Irish regulator failed to prevent the property bubble from ballooning it was really an issue for Dublin to sort out.

For the reasons mentioned above Merkel may want to drag out the use of the ESM as long as possible, and the brake she is applying is the other key element in that famous June 29 statement: banking supervision.

Having a pan-eurozone banking supervisor in place was the price Merkel extracted so that the ESM could be loosened up to deal with bank recapitalisation.

The statement read: “When an effective single supervisory mechanism is established, involving the ECB, for banks in the euro area the ESM could… recapitalize banks directly.”

But it’s the speed at which that can be done which is causing deepening divisions. Merkel told the Bundestag that establishing the so-called Single Supervision Mechanism (SSM) by January 1, 2013 would be a “recipe for disaster.”

Wolfgang Schauble has said that not only would the SSM have to be up and running before direct recapitalising of banks via the ESM could be even contemplated, it would also have to be operating “effectively.”

Casting the process in such vague terms must cause despair among Irish officials. Berlin says it could take a year at least. And how long would it take beyond that to reach a conclusion that the new supervision regime was working “effectively”?

Berlin may have a point when it argues things cannot be rushed. At present the European Commission’s proposals suggest the ECB’s role as supervisor should be such as to cover 6,000 eurozone banks.

Germany wants only “systemically important” cross border banks to be supervised, in other words, only about 24 banks.

A further complication has been reported by the Financial Times. According a leaked note from the European Council’s legal services, the EU treaty would have to be changed to allow the ECB to legally take on a supervisory role.

The other problem is what to do about EU member states which are not in the eurozone but would like to be in the future. How much influence should they have on the creation and operation of a supervision regime?

Take a country like the Czech Republic. It is not currently in the single currency, but it is littered with banks which are headquartered in the eurozone. Should those banks be supervised by the ECB if the Prague has no represenation on the ECB’s governing council?

Conversely, Estonia is in the eurozone, yet many of the banks operating in its territory are Swedish owned, and Sweden is outside the eurozone.

These arguments are likely to dominate the debate over the speed at which a banking supervision system can be set up, but the French president, in an interview with five European newspapers, all but accused Germany of deliberately trying to slow things down to a dangerous degree.

The Irish Government’s strategy heading into the summit, according to an EU official, is to shift the emphasis on getting the SSM up and running by 1 January, rather than to thump the table demanding a deal on legacy debt.

But the truth is that officials have strayed from the cut-and-dried jubilation of 29 June 29 to a more nuanced approach.

Whereas back then it seemed a straightforward breakthrough, there’s now talk of how complex the issue is. What is legacy debt? What should be prioritised?

It is true that the ESM is only officially up and running since 8 October after it was held up by the German Constitutional Court. How it will recapitalise troubled banks will be a technical and legal minefield.

(The European Court of Justice will hold its first hearing next Tuesday into Irish TD Thomas Pringle’s complaint that the ESM Treaty is against EU law, but the chances of the court pulling the entire ESM edifice down are remote.)

According to a well-placed EU source the questions of direct recapitalisation and legacy debt are now being dealt with through a working party which is one level below the Eurogroup Working Group, ie the body made up of officials from the finance ministries of 17 eurozone capitals.

Germany is likely to come under fierce pressure at the summit to take its foot off the brake and encourage the swift implementation of the banking supervision regime, so that everything else can fall into place (including Ireland’s legacy debt).

The pressure will not just be from the likes of Spain, Italy, France and Ireland who have selfish national interests at stake.

Many other observers fear that the sense of drift will drag the eurozone back into the crisis which has recently been alleviated by the ECB’s declaration of intent to stand behind the single currency.

Any sense of indecision will feed back into investor sentiment, and increase the fragmentation of the eurozone, whereby cross-border bank lending is drying up, and companies face wildly differing borrowing costs depending on where they reside in the eurozone.

“Energetic steps towards a resolution of Europe’s current banking fragility are urgently needed, and the euro-area summit statement of June 29 makes the effective establishment of the SSM a precondition for such steps,” writes Nicolas Véron of the think-tank Bruegel.

“The cost to Europe’s citizens of further delay could be extremely significant, not only financially but also politically and socially.”

If the political will is there, the EU has never been shy in the past of setting out a headline aspiration that something should happen even if the technical work has to be sorted out in the meantime.

That could happen for Ireland’s legacy debt, but it clearly isn’t thus far because of German fears – however grounded – and objections.