SAN FRANCISCO, June 2 (Reuters) - California's Assembly approved a bill on Thursday that would require local governments to go into mediation before they could file for bankruptcy, an option some have discussed after Vallejo became the state's biggest city to seek bankruptcy protection.

Vallegjo, a blue-collar town located between San Francisco and the state capital of Sacramento, garnered national attention when it filed for Chapter 9 bankruptcy in 2008 to rein in rising public employee compensation during a slump in revenue.

The bill approved by the Assembly had the backing of unions concerned that cash-strapped local governments could follow Vallejo's example to clamp down on their members' pay and benefits.

The cost of pension and other retirement benefits are a growing concern for local officials as well as for investors in the $2.9 trillion U.S. municipal debt market.

Democrats who control the Assembly approved the bill after Republicans walked out of the chamber during a debate on another bill.

The bill, by Assemblyman Bob Wieckowski, now goes to the state Senate, which Democrats also control.

Wieckowski said the bill would not prevent bankruptcy filings if they are needed.

"As a former council member and vice mayor, I believe that state intervention into local government affairs should only occur for good reason and in exceptional circumstances," Wieckowski said in a statement.

"A local government facing severe financial distress is one of those circumstances," he added. "Bankruptcies could affect borrowing rates for other municipalities, costing taxpayers more in the long run. Even with these facts, my bill does not prohibit bankruptcies as an absolute last resort nor does it require state approval. It is a common-sense step that is far less strict than laws in a majority of other states."

(Reporting by Jim Christie)