WASHINGTON (Reuters) - Progress on European banking union is vital to policymakers' push to encourage cross-border mergers because banks will only be able to leverage synergies if there is a common market for their services, the head of Germany's banks' association said.

Designed after the financial crisis, the banking union aims to centralise supervision of big lenders at the European Central Bank, but little progress has been made as divisions remain over some aspects, such as a joint deposit protection scheme.

"If politicians really want to promote meaningful cross-border mergers in Europe, they need to strengthen the European single financial market," Heiner Herkenhoff, CEO of the Association of German Banks, told Reuters.

The benefits of mergers will only materialise once the banking union is implemented, removing barriers to the free movement of capital and liquidity within the euro zone, he said.

"There is certainly a connection between the banking union and how attractive such mergers can be," Herkenhoff said during Friday's interview in Washington on the sidelines of the International Monetary Fund and World Bank annual meetings.

Herkenhoff's comments come amid upset among German officials over Italian bank UniCredit's possible takeover of German state-backed lender Commerzbank - a stance that pits Berlin against Europe's regulators.

The ECB has said large, European banks can better support the economy and compete with bigger rivals in the United States.

Besides advances in the banking union, Herkenhoff said progress was also needed in the capital markets union, saying it was key to securing the necessary investments for green and digital transitions.

"If we want to rebuild the economy, we need a strong capital market and a capital market union," he said.

An important step could be the securitisation market, he said, talking about a proposal made by the sector on which regulations should be changed, and which the European Commission is currently evaluating.

"Especially for Germany with a high proportion of credit-financed medium-sized companies - which are not on the capital market - it would be extremely helpful if we could relieve bank balance sheets via the securitisation market and thus extend new loans for medium-sized companies," Herkenhoff said.