By Jan Strupczewski and Julien Toyer
The aim is to agree by Wednesday on reducing Greece's debt burden, strengthening European banks, improving economic governance in the euro area and maximizing the firepower of the EFSF rescue fund to prevent contagion engulfing bigger states.
Before the 27 leaders began talks on a comprehensive plan to stem the crisis, German Chancellor Angela Merkel and French President Nicolas Sarkozy held a private meeting with Italian Prime Minister Silvio Berlusconi, officials said.
Diplomats said they wanted to maximize pressure on Rome to implement structural labor market and pension reforms to boost Italy's economic growth potential and reassure investors worried about its huge debt ratio, second only to Greece's.
A German government source said Merkel and Sarkozy underlined "the urgent necessity of credible and concrete reform steps in euro area states," without which any collective EU measures would be insufficient.
Merkel warned in a speech Saturday that if Italy's debt remained at 120 percent of gross domestic product "then it won't matter how high the protective wall is because it won't help win back the markets' confidence.
Arriving for Sunday's sessions of the full EU and the 17-nation euro zone, the leader of Europe's most powerful economy played down expectations of a breakthrough, telling reporters decisions would only be taken Wednesday.
Before then, Merkel must secure parliamentary support from her fractious center-right coalition in Berlin for unpopular steps to try to save the euro zone.
European Council President Herman Van Rompuy, chairing the summit, painted a somber picture of the economic challenges facing Europe in his opening remarks, citing "slowing growth, rising unemployment, pressure on the banks and risks on the sovereign bonds."
"Our meetings of today and Wednesday are important steps, perhaps the most important ones in the series to overcome the financial crisis, even if further steps will be needed," he said.
Finance ministers made progress at preparatory sessions on Friday and Saturday, agreeing to release an 8 billion euro lifeline loan for Greece and to seek a far bigger write-down on Greek debt by private bondholders.
They also agreed in principle on a framework for recapitalizing European banks to the tune of just over 100 billion euros to help them withstand losses on sovereign bonds, although some details remain in dispute.
Sarkozy, who disagreed sharply with Merkel over strategy last week, pressing to put the European Central Bank in the front line of crisis-fighting, said after meeting her again on Saturday he hoped for a breakthrough in the middle of the week.
"Between now and Wednesday a solution must be found, a structural solution, an ambitious solution, a definitive solution," Sarkozy said. "There's no other choice."
Asked whether he was confident of a deal, he replied: "Yes, otherwise I wouldn't be here."
The key outstanding issues were how to make Greece's debt burden manageable and scale up the euro zone rescue fund to shield Italy and Spain, the euro area's third and fourth largest economies, from bond market turmoil that forced Greece, Ireland and Portugal into EU-IMF bailouts.
Markets are concerned that Greek debt, forecast to reach 160 percent of GDP this year, will have to be restructured, but investors do not know what kind of damage they will have to take on their Greek portfolios.
The size of the losses private bond holders would have to suffer was the first issue that will be discussed Sunday.
A debt sustainability study by international lenders showed that only losses of 50-60 percent for the private sector would make Greek debt sustainable in the long term.
This is much more than a 21 percent net present value loss agreed with investors on July 21 and some officials question whether it can be achieved voluntarily, or only through a forced default that would trigger wider market ructions.
Euro zone officials now argue the recession in Greece is much deeper than expected, the country is behind on privatization and fiscal targets and market conditions have deteriorated in the past three months.
To have enough money to support Italy and Spain, if needed, the euro zone wants to boost the firepower of its bailout fund, the 440 billion-euro European Financial Stability Facility.
But public opinion in many countries is strongly against more bailouts, and further commitments to the EFSF could drag down some countries' credit ratings, worsening the crisis.
How to raise the potential of the fund without new cash was probably the most contentious point to be discussed Sunday, but not expected to be resolved until Wednesday.
France and several other countries would like the bailout fund to be turned into a bank so that it can get access to limitless financing from the European Central Bank. But Germany and the ECB itself are adamantly against that.
The most likely solution seems to be that the EFSF would guarantee a percentage of new borrowing of Spain and Italy in a bid to improve market sentiment toward those countries.
Such a solution might help ring-fence Greece, Ireland and Portugal, but some analysts say it could have perverse effects, creating a two-tier bond market in which secondary bond prices would be depressed, and removing the incentive for Italy to take politically unpopular action to cut its debt.
Another possibility under discussion is to create a special purpose vehicle that would enable non-euro zone countries and sovereign wealth funds to
Unless European banks get more capital to cover potential losses on these bonds, other banks will be reluctant to lend to them on the interbank market, triggering a liquidity crunch, now prevented only by stepped-up ECB liquidity provisions.
The European Banking Authority told European Union finance ministers Saturday that if all such bank assets were valued at market prices, EU banks would need 100-110 billion euros of new capital to have a 9 percent core tier 1 capital ratio, an EU source familiar with the discussions said.
Ministers agreed to give banks until June 2012 to achieve this capital ratio, first using their own funds or from private investors, and if that fails, by using public money from governments or as a last resort the EFSF.
With Italy, Spain and Portugal unhappy about the burden being placed on their banks, EU leaders were to discuss the issue Sunday, but the source said it was unlikely an overall sum for recapitalization would be explicitly mentioned.
(Additional reporting by Andreas Rinke, John O'Donnell, Harry Papachristou, Illona Wissenbach; Writing by Paul Taylor)