UPDATE 5-Europe advances towards single banking supervisor
* EU leaders agree legal framework to be completed this year
* ECB-led supervisor to oversee all 6,000 euro zone banks
* Day-to-day supervision of most to be delegated-French source
* Little talk of Spain, Greece aid at summit
By Julien Toyer and Andreas Rinke
BRUSSELS, Oct 18 (Reuters) - European Union leaders took a big stride towards establishing a single banking supervisor for the euro zone, striking a deal under which the bloc's rescue fund could start recapitalising ailing banks next year, a French government source said.
The source told reporters at an EU summit that all 6,000 banks in the single currency area would come under European Central Bank supervision by 2014, but most day-to-day oversight would be delegated to national bodies.
Creating an effective banking union, for which this deal is just a first step, is regarded by the International Monetary Fund and market economists as a key step to overcome the euro zone's three-year-old debt crisis.
The French source said the agreement meant the European Stability Mechanism (ESM) could start injecting capital into troubled banks as early as the first quarter of 2013, but a German source said it was "very unlikely" to happen so soon.
The German government source said the ECB would be responsible for supervising systemically important banks and could oversee others if necessary, emphasising that direct recapitalisation of banks by the ESM could only happen once cross-border banking supervision was firmly in place.
The point when the ECB will effectively become the bloc's banking supervisor is important because it would open the way for the euro zone's bailout fund to inject capital directly into troubled banks, without adding to their host governments' debts.
EU Economic and Monetary Affairs Commissioner Olli Rehn said this was vital "to break the vicious circle between sovereigns and banks".
The legal framework would be completed by the end of this year so the ECB could begin working to implement supervision arrangements from Jan. 1, 2013, starting with banks receiving state aid, the French source told a midnight briefing.
"The entire banking supervision mechanism -- that means the effective supervision of 6,000 banks -- will become reality on Jan. 1, 2014," he said.
The agreement, still to be officially confirmed, appeared to be a defeat for German Finance Minister Wolfgang Schaeuble's efforts to limit the scope of European banking supervision.
The deal came after the leaders of France and Germany, Europe's central powers, held a private meeting after clashing in public over greater EU control of national budgets.
Germany has been reluctant to see its politically sensitive savings and cooperative banks come under outside supervision. It rejects any joint deposit guarantee under which richer countries might have to underwrite banks in poorer states.
German Chancellor Angela Merkel earlier demanded stronger authority for the executive European Commission to veto national budgets that breach EU rules, but French President Francois Hollande said the issue was not on the summit agenda and the priority was to get moving on a European banking union.
For once, the summit was not under intense pressure from financial markets, which have calmed since the ECB pledged last month to intervene decisively if needed to buy bonds of troubled euro zone states to preserve the euro.
Addressing parliament in Berlin earlier in the day, Merkel skirted the issue of a possible credit line for Spain, which EU officials expect Madrid to request within weeks, but reiterated her desire to keep Greece in the currency area despite chronic debt problems.
In Athens, police clashed with protesters hurling stones and petrol bombs during a general strike that brought much of the near-bankrupt country to a standstill.
"We have made good progress on strengthening fiscal discipline with the fiscal pact but we are of the opinion, and I speak for the whole German government on this, that we could go a step further by giving Europe real rights of intervention in national budgets," Merkel told the Bundestag lower house.
A proposal by Schaeuble to create a super-empowered European currency commissioner was a possible way forward, she said, and more European control called for a stronger European Parliament.
Merkel also advocated the creation of a European fund to invest in specific projects in member states which she said could be fuelled by a financial transaction tax which 11 euro zone countries have said they will adopt.
Her call echoed a proposal for the 17-member euro zone to have its own budget -- known in EU jargon as a "fiscal capacity" -- on top of the 27-nation union's common budget, which mostly funds agriculture and aid to poorer regions.
Several states, including the Netherlands, Finland and Austria, were uneasy at the idea but none rejected it outright.
Decisions on institutional reforms are not expected until a December summit.
Since the ECB said last month it was ready to buy the bonds of struggling euro zone states in unlimited amounts, state borrowing costs have fallen sharply, easing the immediate pressure for Spain to seek a bailout.
Spain's 10-year bond yields sank to their lowest since February at an auction on Thursday, helped by Moody's decision this week to leave its credit rating at investment grade.
But rather than signalling that Madrid does not need help, Moody's verdict was predicated on Spain soon applying for a euro zone assistance programme to trigger ECB intervention.
Italy raised a bumper 18 billion euros from a four-year inflation-linked retail bond -- the most ever raised in a single debt offering in European markets -- reducing its need to issue debt before the end of this year.
The leaders agreed at their last summit in June to create a single banking supervisor under the ECB, but tricky legal issues remain and Germany and its north European allies had appeared to be backtracking on elements of the June decision.
The deeper the discussion on banking union goes, the more complex and problematic it will get.
Countries outside the euro zone -- particularly Britain, which has Europe's biggest banking sector -- are concerned their banks could be disadvantaged if a balance is not maintained between the ECB and its oversight of euro zone banks and the powers of other authorities to oversee non-euro zone banks.
And if non-euro zone countries such as Poland join the banking union, as policymakers are hoping, it is unclear what representation they would have within the ECB, since the central bank is currently answerable only to euro zone member states.