Germany's rejection of an idea strongly backed by France showed the potential for more tensions over crisis management, a day after the bloc clinched a deal on euro zone-wide banking supervision and approved long-delayed aid to Greece.

After more than eight hours of late-night talks, leaders promised to push ahead with setting up a mechanism to wind down problem banks and launched talks on how to make countries stick to economic targets with the help of a common fund.

But at an early morning news conference, Merkel made clear that proposals for a substantial "shock absorber" fund and common unemployment insurance were off the table, setting out a far more restrained carrot-and-stick vision.

"We are talking about support linked to improvements in competitiveness." Merkel told reporters of the fund envisaged.

"We are talking about a very limited budget. Not three digit billions, rather 10 or 15 or 20 billion euros."

European Council President, backed by France and other countries, proposed in the run-up to the summit establishing a more ambitious "fiscal capacity" for the euro zone that could form the basis for common debt issuance -- an idea seen with great skepticism in Berlin.

French President Francois Hollande insisted the aim of closer fiscal integration would still be to bolster growth and jobs as well to encourage reform.

However he distanced himself from the idea of a large euro zone standby budget to tackle one-off economic shocks.

"I prefer to talk about a solidarity mechanism," he told a news conference, adding that leaders had charged EU President Herman van Rompuy with setting out the details next year.

With officials concerned about complacency creeping into decision-making now that financial markets have calmed and the crisis seems less acute, leaders appeared intent on showing that they are not relaxing.

That said, German elections late next year and France's reluctance to consider any EU treaty changes needing an awkward referendum before European Parliament elections in 2014 are already putting a brake on the pace of decision-making and limited the summit to verbal commitments rather than decisions.

"CASSANDRAS"

The two-day summit, the sixth and last of 2012, had been intended as a detailed discussion on how best to overhaul economic and monetary union and correct the problems that have fuelled three years of debt crisis.

The meeting was held just hours after EU finance ministers achieved a significant breakthrough in negotiations over a 'banking union' by agreeing that the European Central Bank would be made the chief supervisor of euro zone banks.

That decision, and another by euro zone ministers to release up to 50 billion euros in new aid to Greece, marked two positive developments after a long year of crisis-management and took some of the pressure off leaders to make major strides.

ECB President Mario Draghi hailed the deal on banking supervision, the first stage towards a banking union with more pooled sovereignty, as an important step towards a stable economic and monetary union.

Under the deal, officials said the ECB would regulate some 150 to 200 banks directly - all major cross-border lenders and state aided institutions - with the power to delve into all 6,000 banks in case of problems.

Olli Rehn, the EU commissioner for economic and monetary affairs, said "Cassandras" who had predicted disaster for the euro and a Greek exit had been proven wrong.

But a series of major hurdles remain. The next stages of banking union - creating a resolution fund for winding up troubled banks and coordinating deposit guarantees to protect savers - may be fought over even harder. And then there will be political and financial obstacles to negotiate through the year.

Much of southern Europe faces another year of grinding recession with record unemployment and deepening poverty that will tear at the fabric of wounded societies and may push governments' efforts to reduce deficits further off course.

With Silvio Berlusconi vowing to contest an Italian election early next year, a full bailout of Spain still on the cards and a German election in September casting a long shadow, 2013 promises to be the EU's fourth turbulent year in a row, even without counting ongoing risks from bailout victims Greece, Ireland and Portugal.

Italy is a particular concern if the next government rows back on any of the economic reforms put in place by technocrat Prime Minister Mario Monti, whose time in office has helped stabilize financial markets and stave off the crisis.

"What Mario Monti and his government have done in the past months has contributed strongly to a rise in confidence in Italy," Merkel said.

(Additional reporting by Luke Baker, Paul Taylor, Rex Merrifield, Robin Emmott and Jan Strupczewski in Brussels, Madeline Chambers in Berlin and Gilbert Kreijer in The Hague; Writing by Mark John and Noah Barkin)

• A Permanent Economic Emergency