BRUSSELS (Dow Jones)-- European Union leaders remained deadlocked early Friday morning over key aspects of their anti-crisis response, including a Franco- German proposal to change EU treaties to prevent governments running large deficits.
As they began a critical two-day meeting seen as one of the last chances to arrest an escalating debt and banking crisis, EU leaders also appeared no closer to agreeing how to boost up the funds available for the region's bailout firewall.
Heading into the talks Finnish PM Jyrki Katainen stressed that markets are more interested in agreeing a robust euro-zone firewall than they are in treaty change, while U.K. Prime Minister David Cameron reiterated that he won't sign up to treaty change unless key U.K. interests are protected.
Earlier Thursday, French President Nicolas Sarkozy and German Chancellor Angela Merkel stepped up the pressure on their European peers to swiftly change treaties and accept more centralized control of their budgets, warning that failure to do so would spell disaster for the euro and the whole continent.
Europe's two leading powers have warned that if other countries do not agree to treaty changes, they will push for a separate agreement among the 17 euro - zone members.
"[Chancellor Angela] Merkel's opening salvo at the beginning of the summit is a maximalistic position that the EU's 27 members must adopt an initial agreement for deep-reaching treaty changes. This is what she told a group of leaders before dinner began" late Thursday, a person familiar with the talks told Dow Jones Newswires, adding that talk on EU treaty changes would start later Friday.
Under the threat of a collective downgrade by Standard & Poor's if Friday's summit fails to produce a plan to save the euro and restore market confidence, euro-zone leaders are also expected to discuss a plan to revamp the permanent bailout mechanism and look at proposals to channel funds to the International Monetary Fund through the region's central banks.
The draft guidelines, seen by Dow Jones Newswires, call for the European Stability Mechanism to run alongside the European Financial Stability Facility. They also call for the ESM start date to be brought forward by a year to July 2012 . However the draft text is still preliminary and may well be changed by leaders.
Officials said there was in fact broad agreement among leaders on bringing forward the start date.
However they said the EU was still far from agreeing on whether the two sides should run alongside each other and whether it should be allowed to become a credit institution - effectively turning it into a bank that can borrow from the European Central Bank . Germany is opposed to both ideas.
If the temporary and permanent bailout funds are combined, that could mean the existing cap of EUR500 billion on the firepower of the two funds could be lifted.
The draft document also said the ESM would be allowed to directly recapitalize European banks if needed.
European Council President Herman Van Rompuy has proposed that the ESM, the euro zone's permanent rescue fund, would be more effective if it becomes a " credit institution", which would allow it to access financing from the ECB.
However, Germany rejects any proposal that would give either of the euro zone's bailout funds a banking license, a senior German official said Thursday. Germany also rejects the idea of the ESM and the EFSF running simultaneously, another official said.
The draft guidelines also said euro-area countries would lend money to the IMF through bilateral loans, but offered no further details.
EU officials told Dow Jones Newswires on Thursday that the amount of loans to the IMF could reach EUR200 billion , with EUR150 billion coming from euro-area countries.
The draft included a general outline for the changes needed to achieve a " fiscal compact" of closer economic and fiscal union.
Fiscal coordination and integration would include a new fiscal rule in the constitutions or organic legislation of member states to reach balanced budgets, apart from during economic downturns or severe economic shocks.
Delinquent countries breaching the 3% GDP deficit-level rule would face automatic sanctions but these could be overridden by a qualified majority vote in the euro-area leaders' council.
As the EU leaders gathered in Brussels , the European Central Bank spelled out a raft of measures to help ease pressure on banks, but none to bail out the euro zone's debt-laden governments.
ECB President Mario Draghi returned the benchmark interest rate to an all time low of 1% but gave no signal the ECB was ready to expand its purchases of euro- zone bonds, if the leaders seal a convincing new pact on fiscal policy and economic governance at their meeting Friday.
-By Matina Stevis and Costas Paris, Dow Jones Newswires; 0032-0-27411483; email@example.com
- William Boston , Laurence Norman , Geoffrey Smith and Matthew Dalton contributed to this article