BRUSSELS | Thu Sep 2, 2010 2:16pm EDT

BRUSSELS (Reuters) - European Union diplomats agreed on Thursday to set up pan-EU financial watchdogs by the start of next year, to lead a clampdown on the bankers that many blame for the worst recession in a generation.

The trio of new financial sheriffs, to monitor banks, insurance companies and trading on markets, will be complemented by a group attached to the European Central bank that will keep watch for other economic risks like a property price bubble.

"We have reached a crucial milestone," said Michel Barnier, the European commissioner in charge of a reform of financial rules. "We have reached a political consensus on the creation of a European financial supervisory framework.

"The weaknesses of the national supervisors in the crisis has led to this creation of new powerful European authorities," said Sven Giegold, a German law-maker involved in the negotiations. "This means more Europe."

The shake-up, controversial because Berlin and London feared it would undermine their own authority over the financial sector, establishes agencies that can overrule a national regulator like the Bank of England.

They will be able to intervene in the regulation of individual banks in London and elsewhere. But their resources as well as freedom to sideline national agencies will be limited.

Their creation nonetheless centralizes financial supervision in Europe, a more fundamental shift than any foreseen in Washington.

"We had supervisory failures big time," said Nicolas Veron of Brussels think tank Bruegel.

"So we need to fix the system. The new agencies are starting small but this is the first time in the world that we have the creation of super-national financial authorities."

The agreement on supervision also clears a hurdle to writing many of the other rules for financial reform in Europe, which depend on the creation of the new authorities.

It would, for example, be up to the new markets agency to impose any bans on short-selling if markets wobbled.

"These new authorities will have the final word in mediating a dispute between national authorities in a case like Fortis," said Karel Lannoo of the Center for European Policy Studies, a Brussels think tank.

"They will be in charge and this is a historical change. Although lack of money will hinder their work, some, for example in markets, could become as powerful as the Securities and Exchange Commission."

European countries and law-makers from the bloc's parliament have been bogged down in disagreement over how to reform much of the financial industry.

Talks to break an impasse over new rules for hedge funds and private equity have so far failed to break an impasse over the treatment of off-shore and foreign funds.