European Union leaders piled pressure on Italy on Sunday to speed up economic reforms to avoid a Greece-style meltdown as they began a crucial two-leg summit called to rescue the euro zone from a deepening sovereign debt crisis.
The aim is to agree by Wednesday on reducing Greece's debt burden, strengthening European banks, improving euro area economic governance and maximizing the firepower of the EFSF rescue fund to stop contagion engulfing bigger states.
The euro zone's two main powers, Germany and France, remain at odds over whether to draw the European Central Bank deeper into crisis fighting, officials said.
A document prepared by finance ministers for the 27 EU leaders and seen by Reuters outlined possible guarantee schemes to help banks secure access to wholesale funding at a time when many are shut out of inter-bank lending.
Before the 27 leaders began work on a comprehensive plan to stem the crisis, German Chancellor Angela Merkel and French President Nicolas Sarkozy held a 30-minute private meeting with Italian Prime Minister Silvio Berlusconi, officials said.
Diplomats said they wanted to maximize pressure on Rome to implement labor market reforms and cut red tape for business to raise Italy's growth potential and reassure investors worried by its huge debt ratio, second only to Greece's.
A German government source said Merkel and Sarkozy underlined the urgent necessity of credible and concrete reform steps in euro area states, without which any collective EU measures would be insufficient.
Merkel warned in a speech on Saturday that if Italy's debt remained at 120 percent of gross domestic product then it won't matter how high the protective wall is because it won't help win back the markets' confidence.
Arriving for Sunday's sessions of the full EU and the 17-nation euro zone, the leader of Europe's most powerful economy played down expectations of a breakthrough, telling reporters decisions would only be taken on Wednesday.
Before then, Merkel must secure parliamentary support from her fractious center-right coalition in Berlin for increasingly unpopular steps to try to save the euro zone.
European Council President Herman Van Rompuy, chairing the summit, gave a somber picture of the economic challenges facing Europe, citing slowing growth, rising unemployment, pressure on the banks and risks on the sovereign bonds.
Our meetings of today and Wednesday are important steps, perhaps the most important ones in the series to overcome the financial crisis, even if further steps will be needed, he said in his opening remarks.
Finance ministers made progress at preparatory sessions on Friday and Saturday, agreeing to release an 8 billion euro ($11 billion) lifeline loan for Greece and to seek a far bigger write-down on Greek debt by private bondholders.
They also agreed in principle on a framework for recapitalizing European banks, which banking regulators said need just over 100 billion euros to help them withstand losses on sovereign bonds, although some details remain in dispute.
Sarkozy, who disagreed sharply with Merkel over strategy last week, pressing to put the European Central Bank in the front line of crisis-fighting, said after meeting her again on Saturday night he hoped for a breakthrough in the mid-week.
The key outstanding issues were how to make Greece's debt burden manageable and how to scale up the euro zone rescue fund to shield Italy and Spain, the euro area's third and fourth largest economies, from bond market turmoil that forced Greece, Ireland and Portugal into EU-IMF bailouts.
Markets are concerned that Greek debt, forecast to reach 160 percent of GDP this year, will have to be restructured, but investors do not know what kind of damage they will have to take on their Greek portfolios.
A debt sustainability study by international lenders showed that only losses of 50-60 percent for private bondholders would make Greek debt sustainable in the long term.
This is much more than a 21 percent net present value loss agreed with investors on July 21 and some officials question whether it can be achieved voluntarily, or only through a forced default that would trigger wider market ructions.
Euro zone officials say recession in Greece is much deeper than expected, the country is behind on privatizations and fiscal targets and market conditions have deteriorated in the past three months. Greek officials fear a run on their banks, the biggest holders of government debt, unless the write-down exercise is carefully managed to restore banks' solvency.
To have enough money to support Italy and Spain, if needed, the euro zone wants to boost the firepower of its bailout fund, the 440 billion-euro European Financial Stability Facility.
But public opinion in many countries is strongly against more bailouts, and further commitments to the EFSF could drag down some countries' credit ratings, worsening the crisis.
How to raise the potential of the fund without new cash was probably the most contentious point to be discussed on Sunday, but not expected to be resolved until Wednesday.
France and several other countries would like the bailout fund to be turned into a bank so that it can get access to limitless financing from the European Central Bank. Germany and the ECB itself are adamantly against that.
The most likely solution seems to be that the EFSF would guarantee a percentage of new borrowing of Spain and Italy in a bid to improve market sentiment toward those countries.
Such a solution might help ring-fence Greece, but analysts say it could have perverse effects, creating a two-tier bond system in which secondary market prices would be depressed, and removing incentives for Italy to take action to cut its debt.
Another idea on the table is to create a special purpose vehicle enabling non-euro zone countries and sovereign wealth funds to invest in euro zone government bonds, but EU officials are reluctant to give states like China more say in Europe.
The European Banking Authority told European Union finance ministers on Saturday that if all such bank assets were valued at market prices, EU banks would need 100-110 billion euros of new capital to have a 9 percent core tier 1 capital ratio, an EU source familiar with the discussions said.
Ministers agreed to give banks until June 2012 to achieve this capital ratio, first using their own funds or from private investors, and if that fails, by using public money from governments or as a last resort the EFSF.
With Italy, Spain and Portugal unhappy about the burden being placed on their banks, EU leaders were to discuss the issue on Sunday, but the source said it was unlikely an overall sum for recapitalization would be explicitly mentioned. ($1 = 0.720 Euros)
(Additional reporting by Luke Baker, John O'Donnell, Jan Strupczewski, Harry Papachristou and Illona Wissenbach; Writing by Paul Taylor; Editing by Ruth Pitchford)