French President Nicolas Sarkozy backed down on Sunday in the face of implacable German opposition to demands to use unlimited European Central Bank funds to fight the euro zone's deepening sovereign debt crisis.

European Union leaders wrangled for hours over procedure and made little apparent progress in forging a strategy to overcome the crisis despite pressure from international partners and financial markets for decisive action.

Sarkozy acknowledged that France's proposal to multiply the firepower of the euro zone's rescue fund by turning it into a bank and letting it borrow from the ECB was doomed for now because neither Germany nor the central bank would agree to it.

No solution is viable if it doesn't have the support of all the European institutions, the French leader told a joint news conference with German Chancellor Angela Merkel.

Merkel said only two options remained on the table for leveraging the 440 billion euro ($600 billion) rescue fund, and neither involved drawing on the central bank.

Euro zone officials said the solution was likely to be a mixture of using the European Financial Stability Facility to provide partial guarantees to buyers of new Italian and Spanish bonds and creating a special purpose vehicle with the IMF to attract funds from major emerging countries such as China.

In the only tangible sign of progress on Sunday, leaders said they endorsed a broad framework drafted by their finance ministers for recapitalising European banks to cope with likely losses on Greek and other euro zone sovereign bonds.

But much time was spent on procedural squabbles with non-euro members Britain and Poland demanding that all 27 EU states, including the 10 that are not in the single currency, be fully involved in the crisis response. That forced the calling of another full EU summit for Wednesday evening.

With alarm growing in Washington, Beijing and other capitals about potential damage to the global economy, leaders effectively have four days to work out a comprehensive strategy to halt the crisis that began two years ago in Greece.

They aim to agree on reducing Greece's debt burden, strengthening European banks, improving euro area economic governance and maximising the firepower of the EFSF to try to stop contagion engulfing bigger states. But each of those issues is fraught with difficulty.

After seven hours of EU talks, Merkel told reporters that the decisions to be taken on Wednesday would not be the last step to overcome the crisis.

Before then, she must obtain parliamentary approval from her fractious center-right coalition for the latest series of increasingly unpopular bailout measures.

European Council President Herman Van Rompuy acknowledged the Franco-German differences but said: We are working in a spirit of compromise.

EU leaders pressed Italy to speed up economic reforms to avoid a Greece-style debt meltdown, and Prime Minister Silvio Berlusconi agreed to do so, Van Rompuy said.

Merkel and Sarkozy began the day with a 30-minute private meeting with Berlusconi to underline what a German government source called the urgent necessity of credible and concrete reform steps in euro area states.

Merkel warned in a speech on Saturday that if Italy's debt remained at 120 percent of gross domestic product then it won't matter how high the protective wall is because it won't help win back the markets' confidence.

LIFELINE

Finance ministers made progress at preparatory sessions on Friday and Saturday, agreeing to release an 8 billion euro ($11 billion) lifeline loan for Greece and to seek a far bigger write-down on Greek debt by private bondholders.

They also agreed in principle on a framework for recapitalising European banks, which banking regulators said need just over 100 billion euros to help them withstand losses on sovereign bonds, although some details remain in dispute.

A document prepared by the ministers and seen by Reuters outlined possible guarantee schemes to help banks secure access to wholesale funding at a time when many are shut out of inter-bank lending.

The key outstanding issues were how to make Greece's debt burden manageable and how to scale up the rescue fund to shield Italy and Spain, the euro area's third and fourth largest economies, from bond market turmoil that forced Greece, Ireland and Portugal into EU-IMF bailouts.

Markets are concerned that Greek debt, forecast to reach 160 percent of GDP this year, will have to be restructured, but investors do not know what kind of damage they will have to take on their Greek portfolios.

A debt sustainability study by international lenders showed that only losses of 50-60 percent for private bondholders would make Greek debt sustainable in the long term. A senior German banker close to the talks said bank negotiators had offered to take a 40 percent writedown.

This is much more than a 21 percent net present value loss agreed with investors on July 21 and some officials question whether it can be achieved voluntarily, or only through a forced default that would trigger wider market ructions.

However a Reuters poll last week of economists -- many of them from European banks -- showed they expected private investors would be asked to shoulder losses of around 50 percent on Greek debt.

Euro zone officials say recession in Greece is much deeper than expected, the country is behind on privatisations and fiscal targets and market conditions have deteriorated in the past three months. Greek officials fear a run on their banks, the biggest holders of government debt, unless the write-down exercise is carefully managed to restore banks' solvency.

Analysts say the proposed bond insurance scheme could have perverse effects, creating a two-tier bond system in which secondary market prices would be depressed, and removing incentives for states like Italy to take action to reduce debt.

Another idea on the table is to create a special purpose vehicle with the International Monetary Fund to enable emerging nations and sovereign wealth funds to invest in euro zone government bonds. But some EU officials are reluctant to give states like China more say in Europe.

The European Banking Authority told European Union finance ministers on Saturday that if all such bank assets were valued at market prices, EU banks would need 100-110 billion euros of new capital to have a 9 percent core tier 1 capital ratio, an EU source familiar with the discussions said.

Ministers agreed to give banks until June 2012 to achieve this capital ratio, first using their own funds or from private investors, and if that fails, by using public money from governments or as a last resort the EFSF.

With Italy, Spain and Portugal unhappy about the issue on Sunday, but the source said it was unlikely an overall sum for recapitalisation would be explicitly mentioned.

(Additional reporting by Luke Baker, John O'Donnell, Jan Strupczewski, Harry Papachristou and Illona Wissenbach; Writing by Paul Taylor; Editing by Ruth Pitchford)

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