Under pressure to prevent a catastrophic breakup of their single currency, euro zone leaders yesterday agreed to let their rescue fund inject aid directly into stricken banks from next year and intervene on bond markets to support troubled member states.

They also pledged to create a single banking supervisor for euro zone banks based around the European Central Bank (ECB) in a first step towards a European banking union that could help shore up struggling member Spain.

'It is a first step to break the vicious circle between banks and sovereigns,' European Council president Herman Van Rompuy told a final news conference after talks which stretched right through the night.

The deal was widely seen as a political victory for embattled Italian Prime Minister Mario Monti and his Spanish counterpart, Mariano Rajoy, over German Chancellor Angela Merkel, who had brushed aside any need for such emergency measures earlier this week.

ECB president Mario Draghi endorsed the 'tangible results', which sent the euro nearly two per cent higher and sharply cut Spanish and Italian bond yields.

'I am actually quite pleased with the outcome of the European Council. It showed the long-term commitment to the euro by all member states of the euro area,' Draghi said.

Most economists expect the ECB to cut borrowing costs at its Thursday meeting, which takes place against a darkening economic backdrop. But internal resistance to the central bank reviving its bond-buying programme remains high.

After 14 hours of tense talks, the 17 leaders agreed on a series of short-term steps to shore up their monetary union and bring down the borrowing costs of Spain and Italy, seen as too big to bail out.

To that end the euro zone's temporary EFSF and permanent ESM rescue funds will be used 'in a flexible and efficient manner in order to stabilise markets' to support countries that comply with EU budget policy recommendations, a joint statement said.

It gave few specifics, but euro zone officials said the funds could buy bonds on both the primary and secondary markets on the basis of a memorandum of understanding signed with the requesting state and up to a funding limit to be agreed.

Both Italy and Spain said they did not intend to call on that mechanism to stabilise markets for now, hoping the Brussels agreement will serve as a sufficient deterrent.

In a key concession by EU paymaster Germany, the leaders agreed to waive the ESM's preferred creditor status on lending for Spanish banks, removing a key deterrent to investors buying Spanish government bonds, who feared having to take the first losses in any debt restructuring.

'We have taken decisions that were unthinkable just some months ago,' European Commission President Jose Manuel Barroso said.-Reuters