BRUSSELS (Reuters) - Euro zone leaders bolstered their crisis-fighting arsenal on Friday by giving their bailout funds more flexibility to stabilize bond markets and to directly recapitalize banks in future.
Below are the main elements of the decisions.
The European Central Bank will become the top banking supervisor for banks in the euro zone. The European Union's executive arm is to shortly present a proposal on how to do that and leaders are to consider it by the end of the year.
A senior euro zone official said that because 14 out of 17 euro zone central banks already had supervisory powers the euro zone-wide supervisor could be set up by early 2013.
This is the first step towards a banking union in the euro zone, which will later also incorporate a bank resolution fund and a deposit guarantee scheme.
Under the current rules, if a country does not have enough money to recapitalize its own banks, the government can borrow from the euro zone bailout funds for that purpose. The loans increase the debt of the sovereign.
This creates a the vicious circle of indebted sovereigns borrowing to bailout banks, whose sovereign bond holdings fall in value because the sovereign borrows to bail them out.
Leaders therefore decided that once the ECB becomes the top bank supervisor, and therefore has control over how euro zone banks operate, the euro zone bailout funds will be able to lend directly to banks to recapitalize them.
Direct recapitalization means no involvement for governments and therefore no increase in sovereign debt. This is something the European Commission, the ECB and the International Monetary Fund have long called for, but which Germany did not want until sufficient control via the supervisor is established.
Spain is likely to get between 51-62 billion euros as well as an additional "safety margin" from the euro zone bailout funds to recapitalize its banks.
The loan will initially come from the temporary bailout fund, the European Financial Stability Facility (EFSF) and then be transferred to the permanent European Stability Mechanism (ESM), once it is up and running in July.
The euro zone loan to Spain will not be senior to other Spanish debt - a decision that is likely to comes as a relief to investors who have been selling Spanish debt on concern that they would be paid last, after the ESM, in case of a default.
The lifting of the preferred creditor status of the ESM, however, applies only to the Spanish bank recapitalization loan, not to the whole ESM in general, although some sources say a precedent would effectively have been set.
To eliminate the impact on Spanish debt from the recapitalization loan, the ESM will lend to Spanish banks directly as soon as the ECB takes over the euro zone banking supervision role.
Banks will use the direct loans from the ESM to pay back the Spanish government and therefore the initial increase in Spanish debt will be reversed.
The euro zone bailout funds already had the capability to intervene on primary and secondary bond market of a sovereign, as an addition to a fully fledged bailout or a precautionary credit line.
On the insistence of Spain and Italy, which have seen their borrowing costs surge close to unsustainable levels, euro zone leaders decided to soften slightly the terms on which countries that observe EU rules and recommendations can get euro zone support to lower their borrowing costs.
The EFSF and ESM will be able to use all instruments at their disposal - primary and secondary bond market purchases and various leveraging options - with the decision on which instrument to use to be taken when a government formally applies for such support.
The ECB would act as an EFSF/ESM agent in such operations.
While Spain or Italy would still need to formally apply for euro zone support and sign a memorandum of understanding, as under the previous arrangement, there would be no new, additional measures specified in the memorandum except for recommendations issued under various existing EU procedures.
Also, previously a country had to put up with tight, quarterly supervision of reform progress by representatives of the ECB, the European Commission and the IMF - the Troika - the results of which determined if the government would get the next tranche of emergency aid.
The new arrangement will be less strict. While there will still be economic monitoring, there will be no IMF involvement and therefore no quarterly visits from the Troika.
Reporting By Jan Strupczewski, editing by Mike Peacock