European leaders committed to their goal of establishing a euro-area bank supervisor by year-end, opening the prospect of direct aid to Spain’s banking sector.

The EU will seek to agree on a framework that makes the European Central Bank the main supervisor by Jan. 1, according to conclusions released early Friday after leaders met at a summit in Brussels. The new system, intended to break the link between banks and governments at the root of the region’s financial crisis, will phase in over the next year and could cover all 6,000 euro-area banks by Jan. 1, 2014.

The supervisor can “probably be effectively operational,” allowing the euro bailout fund to lend directly to banks, as soon as 2013, EU President Herman Van Rompuy told reporters after the meeting. He said finance ministers will design rules for such bank rescues.

German Chancellor Angela Merkel, underscoring a go-slow approach, said before direct aid, the bank-oversight system needs to reach “practical completion.”

“Our goal is banking supervision that’s worthy of the name, because we want to create something that’s better than what we currently have,” Merkel told reporters.

The so-called banking union dominated talks at leaders’ 20th crisis-fighting European summit. Leaders praised Greece for its efforts to meet commitments and secure its next aid installments, while sidestepping questions of when and how Spain might secure further assistance.

Spanish and Italian bond yields need to fall further, French President Francois Hollande told reporters. He declared that “the worst has passed” for Europe’s sovereign debt crisis. Leaders didn’t discuss additional assistance for Spain, he said.

The EU has struggled to maintain momentum on a June plan to spur investor confidence by putting the ECB in charge of lenders across the euro area. Divisions have flared over the scope of the ECB’s authority and how losses would be shared.

EU leaders said they’ll consider a “single resolution mechanism” for nations that participate in the bank supervisor once work concludes on existing proposals that affect all 27 EU nations. EU Financial Services Commissioner Michel Barnier already is pressing forward with efforts to bulk up bank shutdown policies across the bloc and shore up national deposit guarantee schemes.

“Other steps also need to be taken quickly starting with harmonization of national resolution and deposit guarantee schemes,” Van Rompuy said at Friday’s press conference.

The EU leaders vowed to ensure that the single supervisor won’t put countries outside the euro area at a disadvantage. They said non-euro nations that join the supervisory framework can receive “equitable treatment and representation,” and intensive technical work in this area will continue.

The leaders’ decisions don’t settle the question of when the European Stability Mechanism will be able to recapitalize banks directly. The plan calls for the supervisor to take charge of big banks and bailed-out institutions first, while also saying direct assistance requires “effective” supervision in place.

In September, Barnier proposed that the euro-area banks supervisor would start on Jan. 1, 2013, with a limited scope, expanding to include all euro banks over 12 months. That phase- in period would allow time for technical work while giving the ECB immediate authority to act on urgent bank supervision issues.

Leaders in June made a calculated decision to start with unified bank oversight and discuss common cleanup costs later. Yet every element of the bank overhaul draws debate back to the fight over who should pay when a bank fails. The EU has already scrapped plans to centralize bank deposit insurance in the near term, instead asking each nation to set up its own system.

Plans to give the ECB oversight powers have helped bolster confidence in financial markets, which also have rallied on expectations Greece won’t get kicked out of the euro, Spain will get the money it needs and the ECB will use its balance sheet to limit potential turmoil. Spanish 10-year bond yields fell to their lowest in six months.

Heading into the summit, Spain was at the center of the most pressing banking issues because of the financial-sector rescue already underway. Spanish Premier Mariano Rajoy wasn’t prepared to make a request for a broader bailout.

Rajoy wants the euro area’s firewall to inject cash directly into its ailing banks, to relieve it of the burden of paying back as much as 100 billion euros in bank- rescue loans. The prospect of direct bank rescues became less urgent after stress tests revealed that Spain’s lenders required less than half of the funds approved by euro-area states, a Spanish official told reporters in Brussels on Friday during a meeting of European Union leaders.

Spain estimated on Sept. 28 it may need about 40 billion euros to recapitalize its banks. The government has played down the necessity of seeking additional aid while pushing for progress on a European banking union.

[Bloomberg]