Under the deal, struck after late-night talks between the 17 leaders of the eurozone, Italy, Spain and other troubled countries will also be able to tap the bloc's temporary EFSF and permanent ESM rescue funds to support their government bonds on financial markets.
Rome and Madrid will be allowed to use the rescue funds to buy their government bonds and lend money directly to recapitalise banks without adding to their public deficit – a major concession by German Chancellor Angela Merkel.
"We affirm that it is imperative to break the vicious circle between banks and sovereigns," said a euro area summit statement published on Friday (29 June).
"The process was tough, the outcome was good," Italian Prime Minister Mario Monti told reporters, adding that Italy did not intend "at this time" to apply for the emergency support.
Countries that requested bond support from the rescue fund would have to sign a memorandum of understanding setting out their existing policy commitments and agreeing a timetable. But they would not face the intrusive oversight of a "troika" of international lenders to which Greece, Ireland and Portugal have been subjected, Monti said.
Bank loans with strings attached
However, loans to troubled banks will come with strings attached. And the rescue funds for the banking sector will only be offered to countries that are in line with the budget deficit ceilings decided at the European level.
"We are opening the possibility to countries that are well behaving to make use of financial stability instruments in order to reassure markets and to get again some stability around some of the sovereign bonds of our member states," said European Council President Herman Van Rompuy at a 4:30 a.m. news conference.
Spain and Italy had withheld their agreement to a growth package at a European Union summit to demand emergency action to bring down their spiralling borrowing costs.
Speaking earlier, French President François Hollande confirmed that Italy and Spain had withheld approval of the growth pact until eurozone leaders agree short-term measures to stabilise markets, but said he expected a deal today as the summit continues.
"Everyone must make an effort so that markets are convinced that the measures are effective, and they must be," Hollande told a news conference. "We all need Italy and Spain to have lower interest rates today and for Spain's banks to be recapitalised because that will bring relief for the eurozone."
'Major game changer' for Ireland
The decision to allow rescue funds to lend directly to recapitalise banks is a "major game changer" for Ireland and will ease its path back to financial markets, the country's deputy prime minister said.
"When the details are worked out between July and the end of the year, it will have a real impact on our debt level and will greatly improve our ability to get back into the market and not to need a second bailout," Eamonn Gilmore told national broadcaster RTE.
In a related decision, European leaders also agreed to create a single supervisory body for eurozone banks.
Van Rompuy said the aim was to create a supervisory mechanism involving the Frankfurt-based European Central Bank by the end of this year, and to break the "vicious circle" between banks and sovereign governments.