After a meeting that lasted until the early hours Friday morning, in which Spain and Italy threatened to block the agreement on a European growth pact, the leaders of the Eurozone gave in to the request of the two countries and agreed to a direct recapitalization of the banking sector, demanded by Spain’s Prime Minister Mariano Rajoy.

This was achieved only after it was agreed that there will be a European banking supervisor under the European Central Bank, the president of the European Council, Herman Van Rompuy, informed on Friday.

The heads of state in the Eurozone also agreed that the credit line of up to €100bn to recapitalize Spain’s troubled banks will be channeled through the European Financial Stability Facility (EFSF) to the Spanish government and transferred to the European Stability Mechanism (ESM) once it comes into effect under the same conditions, that is without putting burden on the sovereign debt, Van Rompuy explained.

According to the leader of the working group of the Europgroup, Thomas Wieser, once the ESM comes into effect, the credit can rapidly be moved from the sovereign debt balance. This means the Eurozone accepted the Spanish prime minister’s two main requests.

Surprising victory

The outcome was a surprise, given that it was not expected that German Chancellor Angela Merkel and her allies would give in to the requests from Spain.

The German leader did not cede, however, on the issue of establishing a single European supervisor over the banking sectors in the member states, which is most likely to be placed under the ECB.

The direct recapitalization of the troubled banks could begin already by the end of this year, after the supervising agency has been established.

Eurogroup gives in to Spain

The Eurogroup thus ended up, after an almost six-hour long meeting, accepting Rajoy’s demands, who requested these measures in order to avoid that the financial aid to the banking sector will affect the country’s sovereign debt.

Rajoy and the Italian Prime Minister Mario Monti threatened to block the summit agreement if the EU members did not take a decision to act in defense of the sovereign debt.

The direct recapitalization will include conditions for the entities that will benefit from the aid as well as for the whole sector or for the whole economy, according to the agreement.

More flexible use of rescue fund

The Eurogroup also agreed on a more “flexible” use of the European rescue fund to buy bonds from countries that are under high pressure on the markets despite the fact that they are introducing necessary reforms, which will enter into effect in October.

These countries will not have to comply with additional requirements. Instead they will only have to comply with the recommendations already made by the EU in terms of economic policies and reduced deficits.

The ECB will be in control over the rescue fund to introduce these operations “in an efficient way.” The heads of states also agreed that they will create a road map for the different phases to establish a “bank union,” as suggested by Van Rompuy. According to him, the aim is to make the euro project irreversible.

The president of the European Council suggested to give more power to the Eurogroup over the national budgets and in the long term to create a European treasury. In return, the possibility to emit Eurozone debt – so-called Eurobonds - will be looked into, a measure strongly opposed by Germany.