By Francesco Guarascio

BRUSSELS (Reuters) - An external early warning system for companies at risk of insolvency is central to a European Commission's draft proposal to cut the region's bankruptcy problem and help banks recoup bad loans.

Non-performing loans (NPLs) on the euro zone's main lenders' balance sheets neared 1 trillion euros ($1.1 trillion) last year, about 9 percent of the bloc's gross domestic product, hitting banks' ability to make money on corporate lending.

EU data shows corporate insolvencies spiked after the 2007-08 financial crisis and are still much higher than before, with half of new firms not surviving their first five years, pushing up unemployment rates in still weak economies.

In a bid to tackle the problem, the Commission wants common EU rules to help troubled companies restructure their business and avoid bankruptcy, a draft law seen by Reuters said. This should also allow creditors to recover their loans more easily.

In Western European countries, nearly 175,000 bankruptcies were recorded last year, up from 130,000 in 2007 before the financial crisis struck Europe, data from Creditreform, a consultancy, shows, with a steep rise in insolvencies mostly in southern European countries. (http://tmsnrt.rs/2dtNHd1)

Meanwhile, banks' non-performing loans as a share of total loans grew threefold in Italy to almost 18 percent, the highest in the euro zone after Greece, nearly five times in Portugal and almost seven times in Spain between 2007 and 2015, World Bank data shows.

In July, Italy's Banca Monte dei Paschi <BMPS.MI>, the world's oldest bank, was forced to devise a rescue plan to sell some of its NPLs and raise capital to deal with the problem.

EARLY WARNINGS

Banking and business representatives welcomed the Commission's draft proposal, which will be finalised and unveiled on Oct. 25, according to the EU Executive's agenda, in the hope it will help reverse Europe's insolvency trend.

The Commission wants an early warning system involving "external intervention" when firms first show signs of stress.

This may be triggered by banks or accountants and lead to a restructuring to salvage the healthy parts of the business, although corporate trade associations would prefer a "voluntary" warning from inside a company, an industry official said.

In a concession to the business lobby, the Commission proposed a 4-month grace period to allow companies to restructure without servicing their debt and tax repayment plans if they are pursuing genuine restructuring, the draft said.

But some bankers object to such an extension.

"Four months is too long," a bank official said, noting there is already a 90-day period during which firms can skip debt payments before they are treated as non-performing.

The plan aims to avoid lengthy litigation and bankruptcies and would rely instead on mediators and supervisors, while creditors will have a say in restructurings, with majority decisions removing the scope for minority shareholder holdouts.

ENDANGERED LIST

Western Europe insolvencies have fallen from a 2013 peak when nearly 193,000 companies filed for bankruptcy, but are more than three times higher than in 2007 in Italy and Portugal.

Bankruptcies represent only a fraction of liquidations, as micro-enterprises usually close without insolvency proceedings.

In Italy, the overall number of companies shrank from more than 4 million in 2008 to 3.8 million in 2014, according to the EU statistics office, while the number of Portuguese businesses dropped by 21 percent and in Spain by around 9 percent.

The EU executive is also reviewing national procedures for banks to recover bad loans, while the European Central Bank launched a consultation in September on dealing with NPLs.

And the head of the European Banking Authority, Andrea Enria, called on Wednesday for public support to develop a European market for banks' bad loans and speed-up their sale.

The Commission proposal will need approval from the Council of EU states and the European Parliament before becoming law and EU countries will then have to translate it into their own laws.

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(Editing by Alexander Smith)