By Annika Breidthardt and Gernot Heller
Leaders of the 17-nation euro zone will now hold a second summit next Wednesday to thrash out the toughest issues of how to maximize the bloc's financial rescue fund and how to reduce Greece's debt, because Merkel will not be empowered to conclude agreements when they meet in Brussels on Sunday.
The German leader stuck to her guns on Friday in rebuffing French pressure to make wider use of the European Central Bank in leveraging the EFSF bailout fund. France argues this is the most effective way of fighting a crisis that began in Greece, spread to Ireland and Portugal and now threatens bigger countries.
"The path is closed for using the ECB to ease liquidity problems," Merkel told her conservative parliamentary caucus in Berlin, according to participants at a closed-door meeting.
A German government spokesman said the most important decisions at the two-part meeting would only come on Wednesday.
The timetable forced the EU to postpone a summit with China next Tuesday, highlighting how the debt crisis is affecting Europe's place in the world. Chinese Premier Wen Jiabao told European Council President Herman Van Rompuy in a telephone call that European leaders should take concrete actions to contain the crisis and stabilize the euro and financial markets.
The outcome will determine whether investors' confidence in the euro area can be restored. It will also influence whether an expected Greek debt write-down triggers a chain reaction of financial turmoil across Europe.
As a first step, leaders of the 27-nation European Union are set to endorse a plan on Sunday to strengthen banks' capital base and may also launch a procedure for longer-term reform of the euro area's economic governance, EU sources said.
European banks will be required to increase their core tier one capital ratio to 9 percent to help them withstand losses on sovereign debt, but it is not yet agreed how long they will be given to raise extra funds.
EU officials said the total amount required was just short of 100 billion euros. Those banks that cannot raise money on the markets will have to turn to national government.
An EU source said France, which has presidential and parliamentary elections from April to June and is desperate to keep its top-notch AAA credit rating, was pressing for banks to be given at least nine months to meet the target.
Berlin and Paris, Europe's two main powers, remain split on how to scale up the 440-billion-euro ($600) EFSF bailout fund to prevent bond market contagion spreading to Italy and Spain, the bloc's third and fourth largest economies.
France fears its credit rating could come under threat if the wrong method is chosen.
Ratings agency Standard & Poor's said on Friday it is likely to downgrade France and four other states if Europe slips into recession. It was the second agency this week to cast doubt on Paris' triple-A rating after Moody's on Tuesday.
There are also differences between Germany and France and between the EU and the International Monetary Fund over how deep a write-down banks and insurers will have to take on Greek bond holdings to make that country's debt sustainable.
Paris and Berlin called on Thursday for negotiations to start immediately with the private sector over its contribution to a sustainable plan for Greece's mountainous debt.
Underlining the threat the euro zone crisis poses to the global economy, President Barack Obama held a video conference with Merkel and French President Nicolas Sarkozy on Thursday, reiterating that he hopes a solution will be in place in time for a summit of G20 leaders in France on November3-4.
Merkel and Sarkozy "fully understand the urgency of the issues in the euro zone and are working diligently to develop a comprehensive solution that addresses the challenge and which will be politically sustainable," the White House said.
The International Monetary Fund and the EU also do not see eye-to-eye over the sustainability of Greek debts, with the IMF concerned that EU projections may be too optimistic and that a deeper debt reduction is needed, EU sources told Reuters.
Without that payment Greece faces default, possibly dragging the larger economies of Spain and Italy into the mire and sending shockwaves through the European banking system.
A German government spokesman said the timing of the second summit would allow the parliamentary budgetary committee to debate plans for the euro zone rescue fund. The committee has to consider such plans, according to German regulations.
HOW TO SCALE UP
The biggest challenge is agreeing on the method of scaling up the EFSF. France has argued the most effective way of leveraging it is to turn it into a bank which could use funding from the ECB, but both the central bank and Berlin oppose this.
Instead, the most likely approach is to use the EFSF to guarantee a portion of potential losses on new euro zone bonds, a way of trying to restore market confidence and convince investors that Italian and Spanish bonds are safe to buy.
By guaranteeing only a portion, perhaps a third or a fifth, of each debt issue, the available EFSF funds would stretch 3-5 times further, increasing it to around 1 trillion euros.
However, analysts are concerned that such a plan could create a two-tier bond market, with bonds that have guarantees trading at a premium to the secondary market -- an outcome that could exacerbate market turmoil.
Markets traded cautiously on Friday after news of the summit delay, with safe-haven German Bund futures higher.
Adding to uncertainty, EU officials said some key euro zone member states were coming to the view that further private sector involvement in Greek debt reduction may have to be forced, not voluntary -- an outcome ruled out up to now.
In July, banks and insurers agreed to contribute 50 billion euros to reducing Greece's debt via a debt buyback and swap agreement, which equated to a 21 percent writedown. That is now seen as insufficient to make Athens' debts sustainable.
Greece remains mired in recession and its overall debt is forecast to climb to 357 billion euros this year, or 162 percent of annual economic output. Economists say Athens is insolvent. ($1 = 0.730 Euros)
(Additional reporting by Andreas Rinke and Madeline Chambers in Berlin, John O'Donnell, Julien Toyer, Jan Strupczewski and Luke Baker in Brussels; Writing by Paul Taylor; editing by Janet McBride)