Negotiations with Greece's private creditors on a second rescue package for Athens have broken down, throwing efforts to resolve the euro zone debt crisis into doubt despite progress in boosting the region's rescue fund to one trillion euros.
German sources said Chancellor Angela Merkel and French President Nicolas Sarkozy were now negotiating directly with representatives of the banking industry, on the sidelines of a euro zone summit, to try to forge a deal in which the banks will accept a writedown of at least 50 percent on their holdings of Greek government bonds.
The talks were expected to drag on deep into the night, with positions far apart on perhaps the most complex element of the three-part comprehensive package that the currency bloc is trying to pull together.
The three elements are so intertwined that euro zone leaders face an all-or-nothing showdown.
They only started now on the hard core of the matter, which is the PSI (private sector involvement), one EU source said.
The leaders earlier made progress on two other elements -- bank recapitalisation and moves to scale up the size of the euro zone's 440 billion euro (384 billioln pound) bailout fund.
A draft statement from the summit, obtained by Reuters, outlined two options to leverage the fund designed to shore up heavily indebted states and thwart market attacks.
It said details would not be nailed down until next month, suggesting the second summit in four days will have sketched broad intentions but failed to produce anything like a detailed master plan to resolve a crisis that threatens the single currency project.
It is going to disappoint the market, particularly given the emphasis policymakers put on this meeting, said Jessica Hoversen, foreign exchange analyst at MF Global in New York.
A senior EU source said the euro zone leaders wanted private sector creditors to accept a writedown of 50 percent or more on their holdings of Greek government debt to reduce Greece's total outstanding private sector debt by around 100 billion euros.
While there is consensus on the need for European banks to raise around 110 billion euros ($150 billion) in extra capital to withstand a potential Greek debt default, governments and banks are at odds over the scale of write-offs.
There has been no agreement on any Greek deal or a specific 'haircut', Charles Dallara, head of the Institute for International Finance which represents private sector creditors, said in a statement. There is no agreement on any element of a deal.
Sources said the IIF could present another offer, a move that is likely to further extend negotiations.
EU leaders did agree the outlines of a package on bank recapitalisation, including raising the core capital ratios of European banks to 9 percent by the end of June 2012, but they did not provide a headline figure, which will depend in part on negotiations over Greek debt.
The European Banking Authority said the euro zone banks needed to raise 106 billion euros of capital to meet that ratio with Greek and Spanish banks facing the most work.
STRONGER RESCUE FUND
For the European Financial Stability Facility, where progress was made, one proposal involves creating a special purpose investment vehicle (SPIV) to tap foreign sovereign and private investors, such as Chinese and Middle Eastern wealth funds, to buy bonds of troubled euro zone countries.
The other method for scaling up the rescue fund, which was set up last year, involves using it to offer partial guarantees to purchasers of new euro zone debt. The two options could be used simultaneously and the International Monetary Fund could also help.
Euro zone finance ministers will be asked to finalise the terms and conditions in November, the draft statement said.
EU sources said the EFSF was expected to be leveraged by something like a factor of four giving it scope of around 1 trillion euros. It has about 250-275 billion euros available given funds set aside for aid to Greece, Ireland and Portugal and for recapitalising the region's banks.
Sarkozy is expected to talk with Chinese President Hu Jintao soon on Beijing's participation in the bailout fund.
U.S. stocks rallied on the pledge to boost the power of the fund, while the euro fell as investors awaited details that will not be forthcoming until next month.
European leaders' pattern of responding too little, too late to a debt crisis that began in Greece has spawned a wider economic and political crisis that threatens to undermine the euro single currency and the European Union project.
Earlier, Merkel won a parliamentary vote of support for strengthening the rescue fund after warning in a dramatic speech that Europe was facing its most difficult situation since the end of World War Two.
Merkel told parliament that private bondholders would have to take a substantial write-down so that Greece's debt could be reduced to 120 percent of gross domestic product by 2020 from 160 percent this year.
Experts said that implied a 50 percent haircut for private investors.
The world is watching Germany and Europe to see if we are ready and able to take responsibility. If the euro fails, Europe fails, said Merkel, in a characteristically sober tone.
No one should take for it for granted that there will be peace and affluence in Europe in the next half century, she said.
Also weighing on the summit was deep concern about Italy, which is now in the bond market firing line.
Under huge pressure from its euro zone partners, Rome promised a package of reform steps to boost growth and control its public debt, including labour and pensions reforms and additional revenues from property divestments.
In a letter sent to the summit in Brussels, the government said it would produce a plan of action to boost growth by November 15, promising to raise the retirement age to 67, cut red tape and modernise state administration to improve conditions for business and raise 5 billion euros a year from divestments and improved returns from state property.
Rome's inability to deliver a substantive plan for reforming its pensions system has raised doubts about Prime Minister Silvio Berlusconi's seriousness in tackling a crisis that threatens the euro zone's third largest economy.
Italy has the euro zone's largest sovereign bond market, with a public debt of 1.8 trillion euros, 120 percent of GDP. If it went the same way as Greece, Ireland and Portugal, the rescue fund would not have enough money to bail Rome out.
Its partners remain sceptical -- a draft summit statement showed euro zone leaders will welcome Italy's plans to increase the pension age but will ask for detailed plans on how it plans to achieve that.
(Additional reporting by Julien Toyer, Jan Strupczewski, Yann Le Guernigou and John O'Donnell in Brussels, Annika Breidthardt and Sarah Marsh in Berlin, Daniel Flynn and Harry Papachristou in Athens, Barry Moody in Rome; Writing by Luke Baker and Mike Peacock; editing by Janet McBride)