By Robin Emmott and Francesca Landini
BRUSSELS, July 10 (Reuters) - Euro zone ministers agreed early on Tuesday to grant Spain an extra year until 2014 to reach its deficit reduction targets in exchange for further budget savings and set the parameters of an aid package for Madrid's ailing banks.
The decisions were aimed at preventing the currency area's fourth largest economy, mired in a worsening recession, from needing a full state bailout which would stretch the limits of Europe's rescue fund and plunge it deeper into a debt crisis.
"The Eurogroup supports the recently adopted Commission recommendation to extend the deadline for the correction of the excessive deficit in Spain by one year to 2014," ministers said in a statement.
No final figure was agreed for aid to ailing Spanish lenders, weighed down by bad debts due to a housing crash and recession, but the EU has set a maximum of 100 billion euros ($123 billion) and some 30 billion euros would be available by the end of July if there was an urgent need.
A final loan agreement will be signed on or around July 20, Eurogroup chairman Jean-Claude Juncker told a news conference.
In one key decision closely watched by investors, ministers agreed that once a single European banking supervisor is set up next year, Spanish banks could be directly recapitalised from the euro zone rescue fund without requiring a state guarantee.
That fulfils an EU summit mandate to try to break a so-called "doom loop" of mutual dependency between weak banks and over indebted sovereigns, but represented a climbdown for hardline north European creditor countries.
In a nine-hour marathon meeting ministers of the 17-nation euro zone also settled a series of long delayed appointments.
But they made no apparent progress on activating the bloc's rescue funds to intervene in bond markets to bring down the spiralling borrowing costs of Spain and Italy, which threaten to drive them out of the market.
The ministers reappointed Juncker as their chairman for a further term of up to 2-1/2 years, though Europe's longest-serving government leader said he intended to step down from the position at the end of this year or early in 2013.
They nominated another Luxembourger, inflation hawk Yves Mersch, to the vacant position on the European Central Bank's six-member executive board, and picked German Klaus Regling to head their permanent bailout fund, the European Stability Mechanism, due to come into force this month.
Regling had already set up and run the temporary European Financial Stability Facility which has funded rescues for Greece, Ireland and Portugal.
As ministers were meeting, a top ECB policymaker warned that Europe's debt crisis was now more acute than the 2008 financial turmoil that felled U.S. investment bank Lehman Brothers.
"The euro zone crisis is now much more profound and more fundamental than at the time of Lehman," ECB Executive Board member Peter Praet told a conference in Lisbon.
The Eurogroup ministers were tasked with fleshing out a bare-bones agreement reached by EU leaders at a summit last month on establishing a European banking supervisor and using the bloc's rescue funds to stabilise bond markets.
But differences persisted between north European countries such as Finland and the Netherlands and southern states led by Italy and Spain.
Earlier, ECB President Mario Draghi endured at times hostile questioning in the European Parliament, notably from German, Dutch and Finnish lawmakers concerned at the prospect of European bank bailouts using taxpayers' money.
A wider gathering of EU finance chiefs on Tuesday will formally ease a deficit reduction goal that has forced Madrid to make punishing cuts that are exacerbating a recession.
Spanish and Italian borrowing costs continued to rise on Monday, with Spain's 10-year bond topping the critical 7 percent level.
Spanish Economy Minister Luis de Guindos spelled out to the euro zone ministers his government's plan for a package of up to 30 billion euros over several years through spending cuts and tax hikes that are due to be announced this Wednesday.
A source close to the Spanish government said 10 billion euros of cuts would come this year and that the measures would include a hike in VAT sales tax, reduced social security payments, reduced unemployment benefits and changes to pensions calculations.
The European Commission proposed in return easing Madrid's deficit goal for this year to 6.3 percent of economic output, 4.5 percent for 2013 and 2.8 percent for 2014.
European Economic and Monetary Affairs Commissioner Olli Rehn said Spain was expected to take additional savings measures very soon to ensure it meets its new targets.
The new targets may still prove hard to reach, according to a draft recommendation from European partners, loosening Spain's goals and demanding the country be subjected to three-monthly checks.
The figures highlighted Spain's dramatic fiscal slippage due to a worsening recession. Madrid was originally meant to cut its budget shortfall to 4.4 percent this year. Prime Minister Mariano Rajoy unilaterally changed the target to 5.8 percent in March before eventually accepting an agreed goal of 5.3 percent.
De Guindos said he was satisfied with the draft memorandum of understanding on the bank rescue, under which Spain will create a single bad bank to house toxic assets from its banking sector.
Spain and Italy continued to press for European action to put a cap on their borrowing costs.
"At this moment the only institution that has enough money to act is the ECB," Spanish Foreign Minister Jose Manuel Garcia-Margallo said at a conference.
But ECB President Draghi told EU lawmakers the key to restoring market confidence was for countries in difficulty to fully implement promised structural reforms and stick to programmes agreed with Brussels and international lenders, even if they caused "social tensions".
He left the door open to a possible further cut in interest rates after last week's 25 basis point cut to 0.75 percent but voiced concern that the ECB was being expected to act "in areas which don't seem to have a connection with monetary policy's traditional remit".
The euro zone ministers also had a first discussion with new Greek Finance Minister Yannis Stournaras but made no decision on any change in Athens' draconian austerity programme, which is off track following June 17 elections.
Juncker said arrangements would be made to ensure a Greek debt repayment due in August did not plunge the country into bankruptcy.
"We will find solutions for August. There's no reason to worry about August," he said without elaborating.