Details on the precise number of banks to be monitored and the powers the supervisor -- the European Central Bank -- will have, however, were left for later.

The decision opens the way for the euro zone's rescue fund to inject capital directly into ailing banks during the course of 2013, but whether that will allow Spain to transfer some of its banking liabilities off the government's books will also not be determined until later in the year.

"There was an agreement, a good agreement, on timing and about the banks as whole," French President Francois Hollande told reporters as he arrived for the second day of the summit following 10 hours of talks on Thursday that carried on into the early hours of Friday.

"There was a willingness to progressively put in place the (oversight) mechanism."

European Council President Herman Van Rompuy said the 27 leaders agreed to adopt a legal framework by the end of this year giving the European Central Bank overall responsibility for banking supervision, with national regulators consulted.

"Once this is agreed, the single supervisory mechanism could probably be effectively operational in the course of 2013," he told a 4 a.m. news conference.

French and EU officials said all 6,000 banks in the single currency area would gradually come under ECB supervision by 2014, starting with banks receiving state aid, then large cross-border institutions, even though a statement from EU leaders did not specify a number or the specifics of a timeline.

One of the thorniest issues -- what representation non-euro zone banks that decide to join the scheme will have at the ECB -- was left to one side and will have to be resolved by the end of the year, along with a number of other legal obstacles.

Even though leaders committed to have the scheme fully in place by the end of 2013, Van Rompuy joked with leaders that he was unlikely to be in office once full supervision was in place, Polish Prime Minister Donald Tusk told reporters. Van Rompuy is due to end his term at the end of November 2014.

Creating an effective banking union, for which this deal was a first step, is regarded by the International Monetary Fund and market economists as a key component in overcoming the euro zone's three-year-old debt crisis.

Hollande said the leaders did not discuss possible financial assistance for Spain, another critical issue in resolving the three-year crisis, but he laid out a series of steps that could help turn a corner.

"Tonight, I have the confirmation that the worst is behind us," he said at a news conference in the early hours. "We are on track to solve the problems that for too long have been paralyzing the euro zone and made it vulnerable."

German Chancellor Angela Merkel said it would take more than a couple of months before the supervisor was fully effective and direct bank recapitalization could be considered.

Germany has been reluctant to see its politically sensitive savings and cooperative banks come under outside supervision. It rejects any joint deposit guarantee under which richer countries might have to underwrite banks in poorer states.

The deal came after the leaders of France and Germany, Europe's central powers, held a private meeting after clashing in public over greater EU control of national budgets.

The point when the ECB will effectively become the bloc's banking supervisor is important because it would open the way for the euro zone's bailout fund to inject capital directly into troubled banks, without adding to their host governments' debts.

A French government source said the European Stability Mechanism (ESM) could start recapitalizing troubled banks as early as the first quarter of 2013, but a German source said it was "very unlikely" to happen so soon.

Merkel earlier demanded stronger authority for the executive European Commission to veto national budgets that breach EU rules. She said a December EU summit would take decisions on these issues of closer euro zone economic governance.

For once, the summit was not under intense pressure from financial markets, which have calmed since the ECB pledged last month to intervene decisively if needed to buy bonds of troubled euro zone states to preserve the euro.

"FISCAL CAPACITY"

The EU leaders issued a statement welcoming Greece's progress towards an agreement with its lenders and saying good progress had been made in putting the bailout back on track.

Merkel also advocated the creation of a European fund to invest in specific projects in member states which she said could be fuelled by a financial transaction tax which 11 euro zone countries have said they will adopt.

Her call echoed a proposal for the 17-member euro zone to have its own budget -- known in EU jargon as a "fiscal capacity" -- on top of the 27-nation union's common budget, which mostly funds agriculture and aid to poorer regions.

Several states, including the Netherlands, Finland and Austria, were uneasy at the idea but none rejected it outright.

Since the ECB said last month it was ready to buy the bonds of struggling euro zone states in unlimited amounts, state borrowing costs have fallen sharply, easing the immediate pressure for Spain to seek a bailout.

Spain's 10-year bond yields sank to their lowest since February at an auction on Thursday, helped by Moody's decision this week to leave its credit rating at investment grade.

But rather than signaling that Madrid does not need help, Moody's verdict was predicated on Spain soon applying for a euro zone assistance program to trigger ECB intervention.

Italy raised a bumper 18 billion euros from a four-year inflation-linked retail bond -- the most ever raised in a single debt offering in European markets -- reducing its need to issue debt before the end of this year.

On the banking union, much work remains to be done and the deeper the discussion union goes, the more complex and problematic it will get.

Countries outside the euro zone -- particularly Britain, which has Europe's biggest banking sector -- are concerned their banks could be disadvantaged if a balance is not maintained between the ECB and its oversight of euro zone banks and the powers of other authorities to oversee non-euro zone banks.

And if non-euro zone countries such as Poland join the banking union, as policymakers are hoping, it is unclear what representation they would have within the ECB, since the central bank is currently answerable only to euro zone member states.

(Additional reporting by Stephen Brown and Madeline Chambers in Berlin, Andreas Rinke and Julien Toyer in Brussels, Harry Papachristou and Lefteris Papadimas in Athens and Gilbert Krijger in Amsterdam. Writing by Paul Taylor, editing by Mike Peacock/Jeremy Gaunt)

• A Permanent Economic Emergency