The euro zone must use its rescue fund to inject money into banks with past debts, the president of the Eurogroup said on Thursday, warning anything less would undermine the bloc's crisis response.

In a major step last June, EU leaders agreed to allow the European Stability Mechanism (ESM) to directly recapitalise banks and reduce the burden on countries such as Spain and Ireland, whose governments are carrying large amounts of debt after propping up banks when real estate bubbles burst.

But Germany, the Netherlands and Finland have since said there was never any question of past bad banking debts being shifted off the states' books and onto the ESM.

Resolving the issue is one of the biggest challenges facing EU finance ministers this year to cement a series of steps taken in 2012 that prevented the break-up of the euro zone.

"There is a major question over the legacy issue and whether we should limit the intervention of the ESM to new problems,» Jean-Claude Juncker, who chairs monthly meetings of euro zone finance ministers, told the European Parliament.

Juncker, Luxembourg's prime minister who leaves the Eurogroup post later this month after almost a decade in the job, said he hoped it would be solved before the end of March.

"I think there must be some degree of retroactivity in the mechanism, otherwise it will lose most of its sense,» Juncker told members of the Parliament's influential Economic and Monetary Affairs Committee.

Direct recapitalisation by the ESM would break the link between indebted banks and euro zone countries, marking a significant step in resolving the bloc's debt crisis that started out with banking problems five years ago.

Berlin, The Hague and Helsinki are worried about the ESM, to which Germany is the biggest donor, taking stakes in banks in exchange for the recapitalisation funds. The maximum lending capacity of the ESM is 500 billion euros ($652 billion).

Juncker urged solidarity, particularly as EU finance ministers in December agreed to set up a single supervisor for euro zone banks - a precondition set by leaders for allowing direct ESM recapitalisation.

"Countries of the north are not more virtuous than countries of the south. They should take a look at their own books,» he said to applause from some MEPs in the packed chamber.

Ireland is burdened with debt that is greater than its annual economic output, representing a big risk for investors in its sovereign debt. But it is close to returning to financial markets and exiting its sovereign bailout, and retroactive help from the ESM could help Dublin on its way back to normality.

Spain could also be saved from any kind of full sovereign bailout if the 40 billion euros in euro zone bank recapitalisation money it has received is not permanently accrued to central government balance sheets.

[Reuters]