Berlin wants the shaky regional banks to consolidate into three institutions from seven at present by the end of next year.
The German bill would establish a federal agency for financial market stabilisation, or FMSA, to be based in the financial capital Frankfurt. The FMSA would take so-called "toxic assets" and non-strategic assets off the Landesbanken's books but would require the banks to present a "sustainable business model as well as an appropriate capitalisation of the transferring credit or financial services institutes."
Banks would also have to present detailed plans for liquidating risky positions and non-strategic operations. The government set up a "bad bank" for private banks last month but had to come up with a separate model for the Landesbanken, which are owned by regional governments and local savings banks associations.
Under pressure from European Union competition officials, the regional banks lost public guarantees that allowed them to lend at favourable rates to companies and individuals and turned to investments in areas like the US market for high-risk, or subprime, mortgages.
The vice-president of the European Commission, German Guenter Verheugen, has said the banks proved to be "world champions in risky business transactions."
Heavy losses in such investments forced regional and federal authorities to draw up rescue plans, since the Landesbanken's role in local lending is still crucial to the biggest European economy. Berlin's insistence on sector consolidation has been resisted by regional authorities, who are reluctant to give up control over banks that underpin local interests.