The European Commission called for direct euro-area aid for troubled banks, and touted a Europe- wide deposit-guarantee system and common bond issuance as antidotes to the debt crisis now threatening to overwhelm Spain.

The commission, the European Union's central regulator, sided with Spain in proposing that the euro's permanent bailout fund inject cash to banks instead of channeling the money via national governments. It also offered Spain extra time to squeeze the budget deficit.

The use of the rescue fund to recapitalize banks "might be envisaged" and would "sever the link between banks and the sovereigns," the commission said today in Brussels. Jose Barroso, the commission's president, said "it is important to use all possibilities offered in terms of flexibility."

Proposals for more liberal use of European bailout money are likely to face resistance in creditor countries such as Germany, Finland and the Netherlands, the scenes of growing taxpayer opposition to more aid.

Signs of stress multiplied in financial markets today. Italy missed its target in a bond auction, driving its 10-year yields as high as 6.01 percent, the highest since Jan. 31. The yield was at 5.95 percent at 2:10 p.m. in Brussels. Doubts over the health of Spain's banks pushed up Spanish 10-year yields as high as 6.70 percent, the highest since Nov. 28. That yield was last at 6.62 percent.

'Exceptionally Tense'

After more than two crisis-filled years and 386 billion euros ($480 billion) in loan pledges to Greece, Ireland and Portugal, "markets remain exceptionally tense and vigilant and confidence is still weak," the commission said.

The euro has tumbled 6 percent in May, hit first by concern that Greek voters will reject bailout conditions, then by worries that Spain will be forced to fall back on a European lifeline. The currency pared today's decline after the commission floated the bank-recapitalization ideas. It last bought $1.2441.

Spain, the 17-nation euro area's fourth-largest economy, is trying to simultaneously plug holes in regional budgets and detoxify its banks, all while struggling to lift the economy out of a recession.

Germany Leads Opponents

Current EU plans call for the 500 billion-euro European Stability Mechanism, set to start up in July, to funnel bank-aid money through national governments and, ultimately, require those governments to pay it back.

Germany is spearheading resistance to direct European financing for banks because that would let governments bypass the conditions set for full aid programs, such as deeper budget cuts and more European intrusion into economic management.

"Direct help for banks is out of the question, that won't fly," Norbert Barthle, the budget spokesman in parliament for Chancellor Angela Merkel's Christian Democratic Union, said in an interview yesterday. Finland is in Germany's camp, Martti Salmi, a Finance Ministry official, said in a telephone interview today.

The commission appealed for a "banking union" that would more tightly integrate supervision and create a pool of European funds to clean up banks with cross-border exposure and segregate their underperforming assets.

"It's hard enough to bail out local banks let alone non- domestic banks," said Harvinder Sian, a London-based fixed- income strategist at Royal Bank of Scotland Group Plc. "A crisis lesson so far is that big ideas coming from Brussels or the guys taking the money are noise up until the point that the Germans get on the same page."


Part of the solution lies in "correct and transparent risk recognition" instead of putting off the reckoning, the commission said. In the wake of the European Central Bank's unprecedented 1 trillion euros in long-term loans, some banks are still using the funds to buy sovereign bonds, binding them more closely to financially shaky governments, the commission said.

The central bank's "accommodative" monetary policy with interest rates at 1 percent limits its scope for spurring the economy, the commission said. It estimated on May 11 that the euro economy will contract 0.3 percent in 2012.

The debt crisis contributed to a greater-than-expected slump in economic confidence in the euro area in May, data showed today. The commission's index of executive and consumer sentiment fell to 90.6, the lowest since October 2009, from a revised 92.9 in April.

More Austerity?

In an assessment by staff economists, the commission said there is little room for deficit-plagued countries to push back planned savings to a later date. Such an easing-up would be punished by markets, it said.

"Member states which face high and potentially rising risk premia do not have much room for maneuver to deviate from their nominal fiscal targets, even if macroeconomic conditions turn out worse than expected," according to the document.

Still, Economic and Monetary Commissioner Olli Rehn said Spain might be granted an extra year, until 2014, to bring its deficit down to the limit of 3 percent of gross domestic product.

The commission would only make that concession if Spanish Prime Minister Mariano Rajoy's government delivers a "solid, two-year budget plan for 2013 and 2014," Rehn told reporters.

Credibility Factor

The commission, which gained new powers to police national budgets in response to the crisis, is trying to crack down on deficits without imposing policies that crimp the economy.

"Credibility of consolidation is one of the key factors," it said.

The commission kept alive the debate over common borrowing by euro-area governments, already rejected by Merkel as at best a goal for the long term and not a way out of the current turmoil.

Debate over euro bonds flared at last week's summit of European leaders, the first for French President Francois Hollande after he took office vowing to challenge the German- dominated budget-cutting creed that has marked the crisis response.

Ideas include a debt-redemption fund proposed by Germany's council of economic advisers and different types of "stability bonds" sketched out by the commission last year. The commission is now working on more concrete proposals.

Passage of a deficit-limitation treaty and the adoption of two laws that further enhance central oversight of national budgets will help pave the way toward common bond sales, the commission said.

"The successful application of the new economic governance framework already in force and in the process of being put in place may be a significant step towards fulfilling the preconditions for common issuance," the commission said.