Eurozone leaders agreed on Friday to take emergency action to bring down Italy's and Spain's spiralling borrowing costs and to create a single supervisory body for eurozone banks by the end of 2012, a first step towards a European banking union.

Responding to pleas from Spanish and Italian leaders, a midnight summit of the 17-nation currency area agreed that euro area rescue funds could be used to stabilise bond markets without forcing countries that comply with EU budget rules to adopt extra austerity measures or economic reforms.

After hours of argument, they also agreed that the bloc's future permanent bailout fund, the European Stability Mechanism, would be able to lend directly to recaptalise banks without increasing a country's budget deficit, and without preferential seniority status.

"The process was tough, the outcome was good," Italian Prime Minister Mario Monti told reporters, adding that Italy did not intend 'at this time' to apply for the emergency support.

Countries that requested bond support from the rescue fund would have to sign a memorandum of understanding setting out their existing policy commitments and agreeing a timetable.

But they would not face the intrusive oversight of a 'troika' of international lenders to which Greece, Ireland and Portugal have been subjected, Monti said.

Spain and Italy had earlier withheld their agreement to a growth package at a European Union summit to demand emergency action to bring down their spiralling borrowing costs, which threaten to force the third and fourth largest economies in the eurozone out of the capital markets.

European Council chairman Herman Van Rompuy said the aim was to create a supervisory mechanism for eurozone banks involving the European Central Bank to break the "vicious circle" of dependence between banks and sovereign governments.

"We are opening the possibility to countries that are well behaving to make use of financial stability instruments in order to reassure markets and to get again some stability around some of the sovereign bonds of our member states," Van Rompuy told a 4.30 am news conference.

"The aim is of course to make the euro an irreversible project," he added.

The euro surged by 1.1 per cent to $1.2581 after the eurozone affirmed its commitment to use its bailout funds more flexibly and efficiently to stabilise markets.

But whether investors regard the deal struck at the 20th summit since the crisis erupted in early 2010 as sufficient remains to be seen. Previous relief rallies have fizzled within days or hours as new doubts set in.

GROWTH PACKAGE DELAYED

Monti and his Spanish counterpart, Mariano Rajoy, had refused to sign off on a 120 billion euro growth package until EU paymaster Germany approved short-term measures to ease their cost of credit.

The clash highlighted tensions between northern creditor countries and heavily indebted southern states over the future shape of the troubled 17-nation currency bloc, now in the third year of a sovereign debt crisis.

German Chancellor Angela Merkel, leader of Europe's biggest economy, said she was satisfied with the result although she had dismissed any need for emergency support for Italian and Spanish bonds earlier this week.

"We made a good decision today, in particular concerning growth and combatting unemployment and also on future measures for the EFSF and ESM. We will continue to work on long-term measures. I believe that we will reach a good conclusion tomorrow," she said.

Eurozone leaders will return on Friday to discuss longer-term plans to build a much closer fiscal and banking union, on which they asked Van Rompuy and the heads of the European Commission, ECB and Eurogroup finance ministers to present detailed proposals by October.

The special terms for Italy and Spain, cobbled together hastily in an effort to halt spreading contagion in bond markets, drew immediate demands for improved terms from one country under an EU/IMF bailout programme.

Irish Prime Minister Enda Kenny said the deal should open the way to 're-engineer the debt burden on our taxpayers' of his country's bailout, granted in 2010 to avert a banking collapse after a real estate bubble burst.

Spain formally applied for up to 100 billion euros in assistance this week to recapitalise banks laden with bad debts due to a similar burst housing bubble.

Cyprus became the fifth country out of 17 eurozone members to appeal for a rescue due to the east Mediterranean island's heavy exposure to Greece's debt crisis.

As the leaders argued, Italy beat Germany 2-1 in the Euro 2012 soccer semi-final, the underdog knocking the favourite out of the contest.

Asked whether he expected Italy to go on to beat Spain in Sunday's final, Monti deadpanned: "I never speculate about financial markets or football."