The European Union's top finance officials hold critical talks on Greece and the worsening situation in Italy on Monday, with concern about the risk of further sovereign debt contagion acute.
Herman Van Rompuy, the president of the European Council, will meet European Central Bank President Jean-Claude Trichet and Jean-Claude Juncker, the chairman of the Eurogroup, for talks in Brussels around midday (1000 GMT), ahead of a meeting of the 17 euro zone finance ministers later on Monday.
Van Rompuy's spokesman described the gathering, which also includes European Commission President Jose Manuel Barroso and the EU's economic and monetary affairs commissioner, Olli Rehn, as a coordination, not a crisis meeting, and said Italy would not be on the agenda.
However, senior EU sources said it would be impossible not to discuss the situation in Italy, the euro zone's third largest economy, following a large sell-off in Italian assets that the Italian media have dubbed black Friday.
Shares in Italy's biggest bank, Unicredit Spa, gyrated wildly on Monday after losing 7.9 percent on Friday, partly because of worries about the results of stress tests of the health of European banks that will be released on July 15. Other banks stocks also fell heavily.
The sell-off has increased fears that Italy, with the highest sovereign debt ratio relative to GDP in the euro zone after Greece, could be next to suffer in the crisis. If that came to pass, the euro zone's existing rescue mechanism, the EFSF, would have insufficient funds to help.
The 10-year yield spread between Italian and German debt widened to a fresh euro-era high of 258 basis points on Monday and bond yields neared the 5.5-5.7 percent area which some bankers think could start putting heavy pressure on Italy's finances.
The market pressure is due partly to Italy's high sovereign debt and sluggish economy, but also due to concern that Prime Minister Silvio Berlusconi may be trying to push out his long-time finance minister, Giulio Tremonti, who has promoted deep spending cuts to control the budget deficit.
We can't go on for many more days like Friday, a senior ECB official told Reuters. We're very worried about Italy.
German newspaper Die Welt quoted an unnamed ECB source as saying the EFSF may have to be doubled in size to 1.5 trillion euros if it is to be capable of coming to the aid of Italy.
Monday's gathering of euro zone finance ministers will focus on a second bailout package for Greece and the need to secure the private sector's involvement in the assistance program, which is expected to total 110 billion euros.
Germany, the Netherlands, Austria and Finland are determined that banks, insurers and other private holders of Greek government bonds should bear some of the costs of helping Athens -- up to 30 billion euros of the total package.
But after more than two weeks of negotiations with bankers represented by the Institute of International Finance (IIF), a lobby group, there has been next to no progress on agreeing a formula acceptable to all sides.
Initially talks focused on a complex French plan for private creditors to roll over up their holdings of Greek debt, buying new bonds as their existing ones matured.
But as that plan has floundered, Berlin has revived a proposal to swap Greek bonds for longer-dated debt that would extend maturities by seven years. Proposals to buy back Greek bonds and retire them have also been floated.
However, both those plans would likely be regarded by ratings agencies as a default, or at best a selective default, which could have profound repercussions for global financial markets. The ECB has said it will not accept anything that is termed a default, a position Germany also maintains.
In a buy-back, the EFSF bailout fund might buy Greek bonds from the market, or the EFSF might lend Greece money to buy bonds. However, these schemes would require further changes to the EFSF's rules and would therefore have to go through national parliaments, officials say.
If euro zone finance ministers do back the idea of a buy-back or a debt swap in an effort to move ahead more rapidly with a second package for Greece, it would effectively mean condoning a default in order to achieve a writedown in the value of Greek debt and make its debt mountain more sustainable.
Senior euro zone officials worry that any further delay in putting together a second package -- which Greece wants by early September -- could further poison investors' confidence in weak economies around the region, prompting more contagion.
We need to move on this in the next couple of weeks. It's not a case of waiting until late August or early September as Germany is saying. That's too late and markets will make us pay for it, a top euro zone official told Reuters on Saturday.
German officials insist they too want to put together the second Greek bailout as quickly as possible, but the private sector's contribution is proving to be a major sticking point.
(Editing by Mike Peacock)