The European Commission threw Spain, the latest frontline in Europe's debt war, two potential lifelines on Wednesday, offering more time to reduce its budget deficit and direct aid from a euro zone rescue fund to recapitalise distressed banks.
Spanish government borrowing costs lurched higher and the Madrid stock market hit a nine-year low with investors rattled by the parlous state of its banking sector fleeing to the relative haven of German bonds.
EU Economic and Monetary Affairs Commissioner Olli Rehn said Brussels was ready to give Spain an extra year until 2014 to bring its deficit down to the EU limit of 3 percent of gross domestic product if Madrid presents a solid two-year budget plan for 2013-14, something it has committed to do.
The concession, which Madrid has not publicly requested, was on condition that Spain effectively reins in overspending by its autonomous regions, makes further financial sector reforms and recapitalises its troubled banks.
While the Commission is responsible for proposing laws, it is member states that decide whether to adopt them.
EU paymaster Germany has so far firmly opposed any collective European banking resolution and guarantee system or any use of bailout funds without a country having to submit to a politically humiliating EU/IMF austerity programme.
Rehn said there were no grounds for giving Italy a similar extension to balance its budget, due in 2013, since unlike Spain its economy is forecast to start growing again next year.
In an economic policy document which laid out some of the dramatic policy proposals which analysts say are needed to tackle the debt crisis, the European Union's executive arm said the vicious circle of weak banks and heavily indebted states lending to each other must be broken and called for a banking union in the euro zone.
Commission President Jose Manuel Barroso said tighter euro zone integration could include a joint bank deposit guarantee scheme to prevent a bank run and euro area financial supervision, saying the mood had changed since member states unanimously rejected a joint deposit guarantee fund only months ago.
"In the same vein, to sever the link between banks and the sovereigns, direct recapitalisation by the ESM (European Stability Mechanism) might be envisaged," the report said.
Permitting the ESM to lend directly to banks would require a change to a treaty in the midst of ratification by member states that might come too late for Spain's needs. Spanish premier Mariano Rajoy backs the idea but Rehn appeared cool to it.
"Direct disbursements to banks are not foreseen as such in the treaty, and therefore this is not an available option ... in terms of direct recapitalisation," Rehn told reporters.
Spain's banking woes - the result of a burst property bubble aggravated by recession - have combined with growing uncertainty about Greece's survival in the euro zone to reignite Europe's sovereign debt crisis.
That drove the euro to a two-year low below $1.2450, while European shares .FTEU3 also fell after Italy had to pay heavily to sell bonds.
Madrid said its bank rescue fund would issue bonds to inject funds into nationalised lender Bankia (BKIA.MC), but that looks expensive with 10-year borrowing costs at 6.65 percent near their euro era peak and close to levels at which Ireland and Greece were forced to seek international bail-outs.
Investors unnerved by Spain's deepening financial crunch pushed Italy's funding costs sharply higher at a bond sale, with 10-year yields topping 6 percent for the first time since January.
In a sign of heightened anxiety in Washington, top U.S. Treasury official Lael Brainard was despatched to hold talks in Greece, Germany, Spain and France "to discuss their plans for achieving economic stability and growth in Europe", the Treasury Department said.