The European Central Bank is willing to let Greece slip into temporary default as part of a crisis response that would involve a bond buyback but no new tax on banks, EU sources said on Thursday.

German Chancellor Angela Merkel and French President Nicolas Sarkozy crafted a common position on a second Greek bailout in late night talks in Berlin with ECB President Jean-Claude Trichet, sources in both governments said.

Minds have been concentrated by the danger Europe's debt crisis could engulf the much bigger economies of Spain and Italy. Greece, Portugal and Ireland have already succumbed.

Merkel told reporters on arrival in Brussels for a crucial euro zone summit: I expect that we will be able to seal a new Greece program. This is an important signal. And with this program we want to grasp the problems by their root.

She gave no details but 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 a second financial rescue.

German government and financial sources said the ECB would accept a selective default as part of a resolution of the country's debt woes through a bond buyback.

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.

CONTAGION

European leaders will try at their fifth summit this year to stop the debt crisis that has forced Greece, Ireland and Portugal into EU/IMF bailouts from sucking in bigger euro zone economies like Italy and Spain, threatening the survival of the 12-year-old single currency.

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 accord.

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 were 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 other euro zone states.

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

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

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.

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 and Andreas Framke in Frankfurt, Andreas Rinke in Berlin, Emilia Sithole-Matarise in London; writing by Andrew Torchia and Paul Taylor, editing by Janet McBride)