European Union leaders have agreed to set up a single eurozone banking supervisor – a major step towards a banking union.

A legislative framework is to be in place by January 1st 2013, with the body starting work later next year.

The European Central Bank-led mechanism will have the power to intervene in any bank within the eurozone.

The deal appears to be a compromise between France and Germany, who earlier disagreed over the timing and over the number of banks the ECB would oversee.

The timetable remains important, because only when the body is fully operational will the eurozone’s rescue fund inject cash directly into ailing banks – so important for countries like Spain.

The deal was, at best, an uneasy compromise between the French and Germans and much wrangling lies ahead.

France and the EU Commission wanted joint banking supervision, with the ECB in the lead role, to become operational in January 2013.

But German Chancellor Angela Merkel stressed that national budget discipline should be the priority.

Germany had been at odds with the European Commission over the scope of the proposed ECB supervision. Under the draft plan, all 6,000 banks in the 17-nation eurozone would be included – Germany wanted it limited to the biggest, “systemic” banks.

Previously, the German government has expressed a desire to retain supervisory responsibility within Germany over the country’s Landesbanks – state-owned banks that play a key role in the economies and state finances of Germany’s federal regions.

Announcing the result of talks early on Wednesday, European Council President Herman Van Rompuy said the 27 EU member states had agreed to set up – by the end of this year – “a Single Supervisory Mechanism [SSM], to prevent banking risks and cross-border contagion from emerging”.

“Once this is agreed, the SSM could probably be effectively operational in the course of 2013,” he said.

EU Commission President Jose Manuel Barroso said that the ECB “will be able to intervene if needed in any bank in the euro area”.

With new supervisory powers the ECB would be able to act early on to prevent a systemically dangerous accumulation of debt on a bank’s balance sheets.

And once the legal framework is in place the new permanent rescue fund, the European Stability Mechanism (ESM), will be able to recapitalize struggling banks directly, without adding to a country’s sovereign debt pile.

ECB supervision will not extend to the UK – Europe’s main financial centre, but outside the euro.

It is more than a theoretical possibility that the interests of the UK and City of London in shaping financial rules will be systematically ignored or overridden, he says.

Both Germany and France appeared to be claiming victory in the negotiations.

German Chancellor Angela Merkel said that the agreement was that “banks must be supervised in a differentiated way. That means that some will be direct… at the ECB level and others indirectly, via the national authorities.”

She also said that ECB President Mario Draghi had told her it would be a matter of some months before the ECB was ready to take on its new role.

Angela Merkel confirmed that the EU bailout funds would not be used to directly inject risk-absorbing capital into troubled eurozone banks until the new supervisory arrangements were in place.

A decision about how to recapitalize Spain’s banks will be made in the next couple of weeks, according to Jean-Claude Juncker, who chairs the Eurogroup of finance ministers.

French President Francois Hollande said there had been no discussion of a possible request by the Spanish government for a bailout of its own finances.

But he said “the worst is behind us”.

“We are on track to solve the problems that for too long have been paralyzing the eurozone and made it vulnerable,” Francois Hollande told a news conference.

EU leaders agreed that the ECB’s new bank supervisory responsibilities would be strictly separated from its role in setting monetary policy.

The banking union plan is fraught with legal complications, as it would give more powers to the ECB and possibly weaken those of national regulators.

There is speculation that it could lead to treaty changes – something that has caused big headaches for the EU in the past.

The UK wants safeguards to protect the powers of the Bank of England.

Jose Manuel Barroso said the arrangement would be “as inclusive as legally possible for non-euro members to join if they want to”.

Earlier, Angela Merkel called for the EU to be given the power to veto member states’ budgets. She said the EU economics commissioner should be given clear rights to intervene when national budgets violated the bloc’s rules.