Italy and Spain stunned Germany by blocking progress until they obtained softer bailout rules in 14 hours of bad-tempered talks
European leaders have pulled back from the brink of disastrous failure in their attempts to rescue the euro, throwing a lifeline to the weakest links in the eurozone by agreeing to shore up struggling banks directly, remove disadvantages for private creditors and move quickly towards a new eurozone supervisory regime for banks.
Amid bad-tempered talks that continued through the night, Italy and Spain stunned the Germans by blocking progress on an overall deal at a two-day EU summit in Brussels until they obtained guarantees that the eurozone would act to cut the soaring costs of their borrowing.
The tough negotiations were deadlocked for hours, prompting the departure from the summit after midnight of the 10 non-euro countries, including Britain, leaving the eurozone leaders to fight it out.
After 14 hours of wrangling, they emerged with a three-point statement rewriting the rules for the eurozone's new bailout regime in a way likely to soften the draconian terms that have accompanied the rescue programmes for Greece, Portugal, and Ireland over the past two years.
The leaders said a new eurozone banking supervisory system should be established by the end of the year. Once it is operational, the eurozone's new permanent bailout fund, the European Stability Mechanism, would be able to recapitalise failing banks directly, without the loans going via governments as at present and adding to national debt burdens. The shift had been demanded particularly by Mariano Rajoy, the prime minister of Spain.
The new supervisory system is likely to come under the authority of the European Central Bank. Under plans being mooted, the new banking regime is to entail pooling eurozone liability for guaranteeing savers' deposits and a common resolution fund for winding up bad banks. But the statement mentioned neither of these two points, which are controversial in Germany, which is reluctant to accept responsibility for the conduct of other countries.
The statement added that in drawing up the terms for up to €100bn (£80bn) for Spanish banks, private creditors would enjoy the same status as the bailout fund in the event of a debt rescheduling. Previously the fund enjoyed "seniority" over private investors.
Herman Van Rompuy, the European Council president who chaired the fractious summit, described the agreement as a breakthrough.
"We are opening possibilities for countries that are well-behaving to make use of financial stability instruments in order to reassure markets and get again some stability around some of the sovereign bonds of our member states," he said.
Eurozone finance ministers are to flesh out the details of the agreement in 10 days' time. It looked as though the shift towards direct help for struggling banks would help Spain but also lead to an improvement in Ireland's bailout terms. The deadlock imposed by Mario Monti, the Italian prime minister, and Rajoy had threatened to wreck ambitions for a "big leap forward" towards political union. The two leaders decided to block endorsement of an EU "growth pact" until it was clear whether the two-day summit would cough up financial aid.
Monti denied Italy intended to request a bailout. All the evidence pointed to a bad-tempered summit. There were also rows about the location of a new European patents court, with Germany, France and Britain at odds over where the institution should be based. With the fate of the currency said to be at stake as well as a radical new blueprint for a federalised eurozone on the table, Europe's leaders appeared bogged down on relatively minor issues.
They were more stridently at odds than ever before in the 30-month euro crisis, but with the stakes arguably at their highest since the currency and sovereign debt crisis erupted in Greece almost three years ago, the real substance of the summit was derailed, at least temporarily, by Italian and Spanish hardball tactics aimed at forcing Germany to soften its tough line on financial assistance to the weaker members of the eurozone.
Monti, who has been plaintively asking Germany to shift from its refusal to accept liability for others' debt, had been expected to deliver a plan late last night calling for help in reducing the cost of borrowing. Instead, he linked up with the Spanish to insist he would not sign off on the growth pact until the overall outcome of the summit became clear, witnesses said. The summit had been expected to quickly endorse the €120bn EU growth and jobs pact, more of a symbolic exercise in shifting the emphasis from austerity, involving little new money.
The tough Italian tactics paid off. The growth pact has been pushed mainly by France and it is the troubled economies of the eurozone, such as Italy and Spain, who are keenest to promote it in an attempt to turn the tide on the German emphasis on austerity and fiscal discipline.
Angela Merkel, the German chancellor, appeared to have little to lose by seeing the meeting blocked and a summit failure. President François Hollande of France sought to put a brave face on what might have turned out to be a debacle for him at his first big EU summit since he needed to take the growth pact home to prove he was already influencing European policy.
There is a risk the deal could yet unravel, though, as governments pick over the immense detail and complexity of establishing a new "banking union", putting the banks under a new eurozone supervisory authority. There will be arguments over how many banks should be covered, over pooled liability. The Germans insist there can be no common responsibility until the common rules are seen to be working properly.
Early on Friday morning, the leaders finally got down to the main topic of the summit, grappling with a "road map" for a 10-year march towards a eurozone political federation, embracing pooled banking, debt and fiscal policies and powers.
German officials maintained a tough line, insisting there were instruments available to help Italy and Spain, such as two eurozone bailout funds. But Italy would have to request aid and accept the same tough terms borne by others who had been rescued. Monti had used the runup to the summit to warn of disaster if his pleas went unheard, while Rajoy had declared that Madrid's borrowing costs were at the brink of what was affordable despite the benchmark 10-year yield falling below 7%.
It remains to be seen whether the steps agreed will be enough to deter market pressure and reverse rising borrowing costs for Spain and Italy. There will also be questions over whether the €740bn in the eurozone's two bailout funds will be enough to resolve a Spanish or Italian crisis.
After talks on Wednesday between Merkel and Hollande, it was clear from the remarks of German officials there was no meeting of minds; Paris and Berlin were seriously split at a summit for the first time in the crisis. "No sign of any warming between Berlin and Paris," said an EU official.
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