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

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

A German source said Paris wanted to tap the euro zone's 440 billion 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.

The French have misunderstood the EFSF. Our position is that banks should seek money in the markets first, then come national backstops, and only when there is no money available would it kick in at the European level, the source said.

There was no immediate comment from Paris, where the government and the Bank of France, which regulates French lenders, had dismissed any need for recapitalization until this week.

A German Finance Ministry spokeswoman said she could not confirm differences between Berlin and Paris on bank recapitalization since talks were still going on.

However, a senior EU diplomat said the dispute surfaced in a tough discussion among euro zone officials this week over whether the EFSF could be used for banks on a precautionary basis or only ultima ratio (as a last resort).

The Brussels diplomat said France's approach was dictated by its determination to limit any risk to its AAA credit rating. France has the highest debt-to-GDP ratio of any of the six triple-A countries in the euro zone at 86.2 percent.

The bottom line for France is the AAA, and that's why the are pushing to do it (recapitalization) through the EFSF, he said.

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

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.

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.

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.

No statement was issued after a two-day EBA board meeting that ended in London on Thursday.

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.

If you mark to market and allow complete defaults then you get to these 180-200 billion, the source said.

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.

After talks with Greek Prime Minister George Papandreou last Friday, Sarkozy recalled the damage wrought when the United States let investment bank Lehman Brothers fail in 2008.

A failure of Greece would be a failure for all Europe, the French leader said. For both economic and moral reasons, we can't let Greece fail.

Merkel has been more circumspect, saying Germany would do everything possible to support Athens if it sticks to its IMF/EU bailout program, but she has acknowledged that a sovereign default cannot be ruled out.

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.

The head of the IMF mission said on Friday he hoped a review of Greece's progress under the bailout deal would be concluded positively soon, but talks were not yet finished.

We have made good progress but there are still important issues that need to be discussed. We are certainly still some way from concluding, the IMF's Poul Thomsen told reporters.

Hopefully, we will conclude positively soon, but we are not there yet, he said.

The outcome of the Merkel-Sarkozy talks will set the agenda for European Union leaders meeting on the crisis on October 17-18.

(Additional reporting by Paul Carrel in Berlin, Philipp Halstrick in Frankfurt, Julien Toyer in Brussels,; Writing by Paul Taylor; editing by Janet McBride)