French and Belgian prime ministers began talks aimed at finalizing a rescue of Dexia bank ahead of a planned board meeting expected to pave the way for a breakup of the first lender to fall victim to the euro zone crisis.

French Prime Minister Francois Fillon arrived at Egmont Palace in Brussels -- also the site of talks on a previous Dexia rescue bid in 2008 -- for talks with Belgian caretaker Prime Minister Yves Leterme. Luc Frieden, the finance minister of Luxembourg, where Dexia also had large operations, is also participating in the talks.

At stake in the talks is how much each government will have to contribute to help wind down Dexia, a thorny subject given that Belgium and France are already struggling to contain outsized deficits.

The negotiations to dismantle the Franco-Belgian lender, which has global credit risk exposure of $700 billion -- more than twice the size of Greece's gross domestic product -- are also being watched closely as investors look for signs Europe is capable of decisive action to resolve its banking crisis.

I am confident we can reach an agreement with French and Luxembourg colleagues and then it is for the Dexia board to decide, Leterme said on Belgian television.

I am convinced that it is possible, though it's not obvious, it's a very complex and difficult case, but that we will manage today, during the night, by tomorrow morning to have an agreement in which Belgium resolves the issue without pushing up the debt level of our country too high.

The Dexia rescue is emblematic of how the need to recapitalize banks is emerging as another unwanted strain for European governments whose budgets are already stretched. Belgium had a debt-to-GDP ratio of 96.2 percent last year, behind only Greece and Italy among euro zone members and on a par with bailout recipient Ireland.

The burden of bailing out Dexia led ratings agency Moody's to warn Belgium late on Friday that its Aa1 government bond ratings may fall.

Dexia, whose board is due to meet in Brussels at 9 a.m. ET, was forced to seek government help this week after a liquidity crunch hobbled the lender and sent its shares into a tailspin.

Dexia, which used short-term funding to finance long-term lendings, has found credit drying up as the euro zone debt crisis worsened, and this situation has been exacerbated by the bank's heavy exposure to Greece.

Dexia's near collapse stoked investors' anxieties about the strength of European banks and coincided with growing talk about coordinated EU action to recapitalize banks across the continent.

French President Nicolas Sarkozy was due to meet German Chancellor Angela Merkel on Sunday in Berlin to thrash out differences on how to use the euro zone's financial firepower to salve a sovereign debt crisis that threatens the global economy.

Germany and France have so far been split over how to recapitalize shaky European banks. Paris wants to tap the euro zone's 440 billion euro ($594 billion) European Financial Stability Facility (EFSF) to recapitalize French banks, while Berlin is insisting the fund should be used as a last resort.

Dexia's overhaul will see its French municipal financing arm split from the group and merged with French state bank Caisse des Depots and Banque Postale, the French post office's banking arm.

The Belgian government wants to nationalize Dexia's largely retail banking business in Belgium.

Healthy units, such as Denizbank in Turkey, will be sold.

A 'bad bank' supported by state guarantees will hold 95 billion euros in bonds, including 12 billion euros of sovereign debt of weaker euro zone periphery nations.

Including 7 billion euros of securities linked to U.S. mortgages, France and Belgium may need to provide guarantees to cover up to 200 billion euros of assets, which would be more than 55 percent of Belgian GDP.

The key issues for Sunday's talks will be how to divide up the 'bad bank' assets, how much Belgium should pay to nationalize Dexia's Belgian banking business and whether others, such as Belgium's regions, would be involved in its purchase.

Dexia's shares have been suspended since Thursday afternoon and have lost 42 percent since last Friday.

($1 = 0.741 Euros)

(Writing by Marie Maitre and Christian Plumb; Editing by Hans-Juergen Peters; Editing by Hans-Juergen Peters)