* EU's Rehn and Barnier answer criticism from George Osborne
* Row simmers after London warns against paring back reform
* Osborne wants flexibility to impose tougher capital rules
By John O'Donnell
BRUSSELS, June 21 (Reuters) - Two top European Union officials have written to British Finance Minister George Osborne in an attempt to defuse a dispute after he warned Brussels against paring back bank capital reform.
In the letter, seen by Reuters, the EU Commissioner in charge of economic affairs, Olli Rehn, and Michel Barnier, who oversees financial reform, seek to allay concerns that have been raised by Britain as well as others such as Sweden.
But officials arguing for more ambitious reform said on Tuesday that the commissioners offered no concession in their letter that could resolve the dispute.
Osborne is worried the European Union will introduce laws that make it difficult for countries like Britain to tighten capital controls on banks beyond the levels which have been agreed internationally.
His concerns were prompted by a draft EU law, written by the European Commission, which signalled its intention to stick to the letter of the Basel III accord, spelling out the amount of capital banks should hoard for a rainy day.
"The natural thing to do would be to say the more capital the better," said one official, adding that the letter offered "nothing". "The position that they take is a bit odd when you compare it to other areas where they want as much as possible."
RETHINK
Osborne wants flexibility to follow Switzerland in forcing banks to keep more capital to prevent a repeat of the crisis that forced Britain to launch a string of rescues, including a 66-billion-pound bailout for Royal Bank of Scotland .
Earlier this year, Britain joined six other countries including Sweden, in writing to the EU executive, asking it to rethink its plans.
Osborne said that enforcing only the bare minimum capital levels threatened the region's credibility, battered after a banking crisis spilled over into sovereign debt.
In the letter sent on June 1, Rehn and Barnier say the new EU rules would give countries the flexibility to "impose additional capital requirements to one or several institutions where justified by the ... circumstances".
It says countries remain free to use "countercyclical capital buffers", a variable requirement on banks to set aside more reserves in good times and fewer in bad.
"The framework would provide a certain flexibility in order to address some country specifics," Rehn and Barnier write.
But Britain wants the power to set the core capital ratio -- a key measure of financial health -- at a level higher than that in Germany, for example.
Core capital, which includes a bank's reserves or the capital of shareholders, is the safest form of back-up in a downturn because it can be used immediately to cover losses from unpaid loans.
Tweaking cyclical buffers, officials say, is less useful because attempts to alter them could get bogged down in arguments with industry.
Furthermore, Britain and others suspect that Barnier, the former French foreign minister now in charge of financial regulation, may want to impose one capital standard across the EU to protect lenders in France and Germany.
Were the British government allowed to make banks set aside more capital, its lenders could become more attractive for investors and savers, putting pressure on continental banks to bolster reserves in the same way.
The draft law, to be published soon, will then go to EU countries and the European Parliament for approval. It is unlikely France and Germany would push it through without Britain's backing. (Editing by Alexander Smith)