Un­der pres­sure to pre­vent a cat­a­stroph­ic breakup of their sin­gle cur­ren­cy, eu­ro zone lead­ers agreed on Fri­day to let their res­cue fund in­ject aid di­rect­ly in­to strick­en banks from next year and in­ter­vene on bond mar­kets to sup­port trou­bled mem­ber states. They al­so pledged to cre­ate a sin­gle bank­ing su­per­vi­sor for eu­ro zone banks based around the Eu­ro­pean Cen­tral Bank in a land­mark first step to­wards a Eu­ro­pean bank­ing union that could help shore up strug­gling mem­ber Spain.

"It is a first step to break the vi­cious cir­cle be­tween banks and sov­er­eigns," Eu­ro­pean Coun­cil pres­i­dent Her­man Van Rompuy said. The deal was wide­ly seen as a po­lit­i­cal vic­to­ry for em­bat­tled Ital­ian Prime Min­is­ter Mario Mon­ti and his Span­ish coun­ter­part, Mar­i­ano Ra­joy, over Ger­man Chan­cel­lor An­gela Merkel, who had brushed aside any need for such emer­gency mea­sures ear­li­er this week.

ECB pres­i­dent Mario Draghi en­dorsed the "tan­gi­ble re­sults", which sent the eu­ro near­ly two per cent high­er and sharply cut Span­ish and Ital­ian bond yields. Eu­ro­pean shares rose, led by bank­ing stocks buoyed by the prospect of moves to back­stop the fi­nan­cial sys­tem. "I am ac­tu­al­ly quite pleased with the out­come of the Eu­ro­pean Coun­cil. It showed the long-term com­mit­ment to the eu­ro by all mem­ber states of the eu­ro area," Draghi said.

Mar­ket par­tic­i­pants wel­comed the out­come as a sub­stan­tial step to re­store con­fi­dence in the 17-na­tion eu­ro zone, which was salut­ed by a more durable ral­ly than pre­vi­ous sum­mit out­comes. "It's inch­ing clos­er to a bank­ing union, and the clos­er we get to a bank­ing union would put (the EU) well on the road to a fis­cal union," said Art Hogan, man­ag­ing di­rec­tor of Lazard Cap­i­tal Mar­kets in New York.

UN­THINK­ABLE DE­CI­SIONS

In a key con­ces­sion by EU pay­mas­ter Ger­many, the lead­ers agreed to waive the ESM's pre­ferred cred­i­tor sta­tus on lend­ing for Span­ish banks, re­mov­ing a key de­ter­rent to in­vestors buy­ing Span­ish gov­ern­ment bonds, who feared hav­ing to take the first loss­es in any debt re­struc­tur­ing.

"We have tak­en de­ci­sions that were un­think­able just some months ago," Eu­ro­pean Com­mis­sion pres­i­dent Jose Manuel Bar­roso said. De­spite the con­ces­sions by Berlin al­low­ing eu­ro zone res­cue funds to be used more flex­i­bly, ques­tions re­mained about the terms, size and su­per­vi­sion of any fu­ture aid for Spain and Italy.

There was al­so no com­mit­ment for now to back up a Eu­ro­pean bank su­per­vi­sor with a joint de­posit guar­an­tee or a com­mon res­o­lu­tion fund, to avert cap­i­tal flight and tax­pay­er loss­es. How­ev­er, one EU of­fi­cial said that let­ting the ESM lend di­rect­ly to banks once the su­per­vi­so­ry body is up and run­ning was a back­door route to clos­er fis­cal union.

Mon­ti, de­ter­mined to avoid the po­lit­i­cal stig­ma of the bailout terms im­posed on Greece, Ire­land and Por­tu­gal, said coun­tries that com­plied with EU bud­get rec­om­men­da­tions would not face ex­tra aus­ter­i­ty con­di­tions or be sub­ject to in­tru­sive in­spec­tions by a "troi­ka" of in­ter­na­tion­al lenders.

Ea­ger to avoid the im­pres­sion that she had blinked first, Merkel said strict con­di­tion­al­i­ty would still ap­ply to the use of res­cue funds and coun­tries would face strin­gent mon­i­tor­ing by the EU Com­mis­sion and the ECB. Asked if she had yield­ed to pres­sure, she said: "There is clear­ly pres­sure from fi­nan­cial mar­kets. Some coun­tries are in a dif­fi­cult sit­u­a­tion. The high in­ter­est rates af­fect the debt but al­so the re­al econ­o­my. We had an in­ter­est in find­ing so­lu­tions."

CAU­TIOUS OP­TI­MISM

Econ­o­mists ap­plaud­ed both the short-term mea­sures to steady mar­kets and the longer-term di­rec­tion, say­ing that for once, af­ter 20 sum­mits since the cri­sis be­gan in ear­ly 2010, eu­ro zone lead­ers had ex­ceed­ed ad­mit­ted­ly low ex­pec­ta­tions. "I think the ECB be­ing made the bank­ing su­per­vi­sor is ac­tu­al­ly the biggest long-term step be­cause it points the way to bank­ing union," said Megan Greene, an­a­lyst at Roubi­ni Glob­al Eco­nom­ics, which is of­ten gloomy about the eu­ro zone's fu­ture.

"The move to re­cap­i­talise banks di­rect­ly is a big deal and will help to break the 'vi­cious cir­cle' be­tween banks and sov­er­eigns that has been at the very heart of this cri­sis," said ABN AM­RO econ­o­mist Nick Kou­nis, al­though he added that the eu­ro zone re­mained "in a mud­dling-through sce­nario".

Reuters