Euro zone finance ministers are poised to initiate a fundamental review of Ireland’s bank bailout after EU leaders moved to give their new rescue fund the power to recapitalise banks directly.
Taoiseach Enda Kenny said the breakthrough, which follows a big policy shift by German chancellor Angela Merkel, opens up the prospect of a significant easing in the burden of Ireland's banking debt.
"The end result will be a re-engineering to lessen the debt burden on our people," the Taoiseach told reporters in Brussels.
The development came as EU leaders took steps to calm intensive investor pressure on Spain and Italy, whose leaders threatened not to back a new plan to stimulate economic growth if moves were not made to tackle the immediate crisis.
In addition to the direct rescue of Spain's banks, Europe's bailout funds will intervene in bond markets to keep a lid on Italian borrowing costs.
Financial markets responded favourably to the manoeuvre, with Irish borrowing costs for 10 years dropping to their lowest level since the month before the November 2010 EU-IMF bailout.
"It is a first step to break the vicious circle between banks and sovereigns," said European Council president Herman Van Rompuy.
Although Dublin will develop detailed proposals to recast the banking arrangements, the negotiation of new terms is likely to continue for months.
The Coalition's campaign for a better deal has centred to date on the €47 billion Anglo Irish Bank promissory note scheme, but Mr Kenny said it was open to Europe to consider a variety of options.
The ministers will consider their next move at a meeting in Brussels on Monday week. At Dr Merkel's request, however, the current regime will not be changed until a new pan-European banking regulator takes office. Member states aim to complete this step, which will see the European Central Bank take a direct role in banking supervision, by the end of the year.
Government sources expressed the hope that a deal to rework the bank rescue could be finalised before the budget in December.
However, the Taoiseach and Minister for Finance Michael Noonan warned that a harsh budget was still likely. "It does not change the fact that we still have a very difficult and challenging budget coming up," Mr Kenny said. "We have to deal with our deficit and that is what we are going to do."
For months Germany resisted Dublin's demands to change the banking rescue, arguing that such a move would send a negative signal about a bailout which was perceived to be proceeding well.
"An examination by finance ministers will show what can be done," a German source in Brussels said.
The climbdown by the chancellor on direct bank rescues came less than three weeks after she rejected Spain's pleas to pursue that path.
At the Irish Government's insistence, a communique issued by euro zone leaders after 4am yesterday made a direct reference to Ireland and said cases similar to Spain's would be treated equally. "The euro group will examine the situation of the Irish financial sector with a view to further improving the sustainability of the well-performing adjustment programme," it said.
A high-level European official said it was "difficult to deny" the position advanced by Mr Kenny and Irish negotiators. "They had an argument: 'You are doing for Spain something you didn't do for us', and so there was some kind of understanding."
Dr Merkel faced parliamentary votes last night to endorse Europe's fiscal treaty and the treaty to set up the ESM. She won the first of those when the lower house voted by a large majority for both treaties.
The Minister for Public Expenditure and Reform Brendan Howlin said a banking regulator for the Eurozone now needed to be developed. Speaking at the Labour Party Tom Johnson summer school in Kilkenny today, Mr Howlin said this regulator would be in charge of ensuring that banks properly manage risk.
"And there is also a clear need for a European system for bank resolution, so that when a bank fails there are clear rules about who carries the cost, and to the extent that the answer is taxpayers, the cost will be managed on a cross-European basis," he said.