Germany and France are willing to allow Greece to slip into a temporary default as part of a bond buyback plan aimed at preventing Europe's debt crisis from spreading, and have ruled out a levy on banks.

As so often in the debt crisis sweeping Europe, German and French agreement is key to any deal.

The accord came after seven hours of talks late into Wednesday night between German Chancellor Angela Merkel and French President Nicolas Sarkozy in Berlin, sources in both governments said. The meeting also involved European Central Bank head Jean-Claude Trichet.

Dutch Finance Minister Jan Kees de Jager said a short-term or selective default for Greece, previously opposed by the ECB, was now a possibility.

The demand to prevent a selective default has been removed, he told the Dutch parliament.

Euro zone sources said a buyback of discounted Greek bonds to help reduce Athens' crippling debt pile was now seen as the most promising way of making private investors contribute to the cost of another financial rescue.

One source said the Franco-German agreement had Trichet's blessing. You should assume that there will not be a banking tax, the source told Reuters.

While few other details of the Franco-German deal emerged, the sources said it would include private sector involvement.

The euro zone sources said a buyback of Greek bonds on the secondary market was the only form of private sector involvement that might not trigger a selective default and it was now at the heart of the talks.

The risk premium investors demand to hold peripheral euro zone government bonds rather than benchmark German Bunds fell on Thursday on news of the Franco-German agreement.

There are huge expectations something will be done... the big disappointment could come from how quickly they can implement things. They can agree principles but implementation will take a long while, said Peter Schaffrik, a strategist at RBC Capital Markets.

The 115 billion euro second Greek rescue package would involve both more official funding from the euro zone rescue fund and the IMF and a contribution by private sector bondholders on which two senior bankers will make a presentation to leaders on Thursday, the sources said.

Baudoin Prot of BNP Paribas, the French bank with the biggest exposure to Greek debt, and Deutsche Bank chief executive Josef Ackermann, chairman of the International Institute of Finance, a banking lobby that has led talks among bankers, will attend, banking sources said.

The leaders are due to meet at 1100 GMT but the start could well be delayed as euro zone sherpas work to thrash out details of an agreement, officials said.

The aim is to make Greece's debt more sustainable and prevent fears of a disorderly default from poisoning access to the bond market for bigger states such as Italy and Spain.

SUPPLEMENT

The new bailout would supplement a 110 billion euro ($156 billion) rescue plan for Greece launched in May last year.

Ireland and Portugal have since received similar rescues and Italian and Spanish debt has come under attack this month, spreading the crisis to countries that are too big to save with the EU's current fire-fighting instruments.

Worried about the impact on financial markets and wary of angering their own taxpayers, euro zone governments have struggled for several weeks to agree on major aspects of the plan, especially a contribution by private sector investors.

The euro rose moderately against the dollar in response to the Franco-German announcement. Providing fresh money to Greece and arranging for commercial banks to participate could face legal and technical obstacles.

The head of the European Commission, Jose Manuel Barroso, warned on Wednesday that the global economy would suffer if Europe could not summon the political will to act decisively on Greece.

Britain's finance minister George Osborne, in an interview with the Financial Times published on Thursday, said failure could produce an economic crisis as serious as the recession which followed the global credit crash of 2008.

NOT CLEAR

Four competing proposals have been circulating for private sector involvement: a rollover of Greek government bonds as they mature, a swap of bonds for debt with longer maturities, a buyback of Greek debt at a discount to its face value, and a tax on European banks.

Germany and France had been at odds on these proposals, with Berlin promoting a bond swap and France suggesting a rollover or a tax. The ECB had complicated the argument by opposing any step that might cause credit rating agencies to declare Greek debt in default.

The IMF, whose new head Christine Lagarde will also attend, has told euro zone leaders they should put more money into their 440 billion euro European Financial Stability Facility, and let it buy government bonds of weak states on the secondary market. Investors also hope it will be permitted to extend precautionary credit lines to countries at risk.

Germany has previously blocked allowing the EFSF to buy bonds, which would require changes in the fund's rules that would have to be ratified by national parliaments, and could fall foul of critics in Germany, the Netherlands and Finland.

Thursday's summit is very unlikely to mark a complete resolution of the crisis, as Merkel herself acknowledged earlier this week.

A second bailout may simply keep Greece afloat for a number of months before a tougher decision has to be made on writing off more of its debt.

Many economists believe the only way out of the euro zone's debt crisis in the long run may be closer integration of national fiscal policies -- for example, a joint euro zone guarantee for countries' bonds, or issuance of a joint euro zone bond to finance all countries.

Germany has firmly ruled out such steps, but Osborne said the second Greek bailout would only be a step toward a necessary fiscal union in the euro zone.

(additional reporting by Emmanuel Jarry in Paris, Philipp Halstrick in Frankfurt, Emilia Sithole-Matarise in London; writing by Andrew Torchia and Paul Taylor, editing by Janet McBrde)