By Michele Kambas and Julien Toyer
NICOSIA/MADRID (Reuters) - Cyprus said on Monday it would seek a European bailout to handle fallout from the Greek crisis, becoming the fifth euro zone country needing rescue funds hours after Spain formally requested help for its banks.
Despite the spreading crisis, German Chancellor Angela Merkel dashed any lingering hope in financial markets that Europe would issue common euro zone bonds to underpin its single currency.
Cyprus, the third smallest economy in the euro zone, announced it would apply for European Union funds as it needs to raise at least 1.8 billion euros - equivalent to about 10 percent of its domestic economic output - by the end of this week to recapitalize Cyprus Popular Bank.
"The purpose of the required assistance is to contain the risks to the Cypriot economy, notably those arising from the negative spill over effects through its financial sector, due to its large exposure in the Greek economy," a government announcement said.
Nicosia has to satisfy European regulators by June 30 about the health of Cyprus Popular Bank which has suffered heavy losses on Greek debt. It may seek more.
Greece's own crisis deepened on Monday when its new finance minister who was appointed only last week resigned because of ill health, throwing the government's drive to soften the terms of its EU/IMF bailout into confusion shortly before a European summit.
Tiny Cyprus, one of the euro zone's smallest economies, has a disproportionately large off shore financial sector heavily exposed to Greece. Greece, Ireland and Portugal have already taken EU rescues for their sovereign finances, and Spain is looking for an EU bailout for its banks.
The euro and shares fell on Monday due to investors' skepticism that an EU summit this week would act decisively on the bloc's debt crisis.
At the two-day Brussels summit starting on Thursday leaders will discuss a cross-border banking union, closer fiscal integration and the possibility of a debt redemption fund.
But Merkel, who leads Europe's biggest economy and the main contributor to its rescue funds, said sharing debt liability within the 17-nation euro area would be "economically wrong and counterproductive".
France, Italy and Spain have pushed hard for steps towards mutualising debts and liabilities through a joint bank deposit guarantee, a common bank resolution fund and issuing common euro zone bonds. The conservative German leader adamantly rejects such ideas and is keen to squelch them before the meeting.
"When I think of the summit I feel concerned that yet again we will have too much focus on all kinds of ways of sharing debt," Merkel told a conference in Berlin.
Critics say that by refusing any such collective solutions, Berlin risks unleashing speculative attacks on Spanish and Italian bonds, hastening rescues which the euro zone's rescue funds are too small to manage.
Spanish and Italian bond yields rose on Monday as doubts spread that the EU summit would take any decisive action to stem the crisis, which began in late 2009. The euro fell against the dollar and investors sought shelter in U.S. government debt.
Spanish Economy Minister Luis de Guindos asked for up to 100 billion euros ($125 billion) in a letter to Eurogroup chairman Jean-Claude Juncker, saying the final amount of assistance would be set at a later stage. The letter formalizes Spain's request for the bailout, agreed on June 9.
He confirmed his intention to sign a Memorandum of Understanding for the package by July 9 and said the amount should be enough to cover all banks' needs, plus an additional security buffer.
The EU's top economic official, Olli Rehn, said a deal on terms for the loan from Europe's bailout funds could be concluded within weeks.
"The policy conditionality of the financial assistance, in the form of an EFSF/ESM loan, will be focused on specific reforms targeting the financial sector, including restructuring plans which must fully comply with EU state aid rules," he said.
The rescue is intended to help Spanish lenders recover from the effects of a burst real estate bubble and a recession, which have piled up bad loans and sinking property portfolios.
Prime Minister Mariano Rajoy told business leaders he would soon take new measures to revive economic growth and create jobs. He gave no details but said the government remained committed to cutting the public deficit.
Two independent audits last week put the Spanish banks' capital needs in a severe economic downturn at up to 62 billion euros, and a fuller audit will be delivered in September.
Some market economists believe the rescue is merely a prelude to a full bailout for the Spanish state, which saw its borrowing costs soar to euro era record levels above 7 percent early last week, although they have eased to below 6.50 percent.
A working document prepared by top EU officials calls for the gradual introduction of a banking union, starting with supervisory power for the European Central Bank and developing a deposit guarantee scheme based on pooling national systems, with a levy-funded bank resolution fund.
Berlin has so far rejected any joint deposit guarantee or resolution fund, as well as proposals that euro zone governments should assume joint liability for each other's debts.
Finance Minister Wolfgang Schaeuble hammered home the message in weekend interviews, saying that throwing more money at the crisis would not solve the problems, and telling Greece it must try harder rather than seeking to soften bailout terms.
He cited Ireland and Portugal as countries that were succeeding in their EU/IMF adjustment programs and said Greece had not made a sufficient effort.
Merkel and French President Francois Hollande, whose relationship is testy, will have one more try at narrowing their differences before the summit on Thursday and Friday.
The German leader has shown no sign of relenting in her refusal to take on new liabilities for German taxpayers until other euro zone states agree to hand more sovereignty over national budgets and economic policies to EU institutions.
Hollande took the opposite position on Friday, saying there could be no more transfer of sovereignty until there was greater "solidarity" in the EU.
The two-day EU summit will be the 20th time leaders have met to try to resolve a crisis that has spread across the continent since it began in Greece in early 2010.
Greece's new prime minister, Antonis Samaras, who is recovering from eye surgery on Saturday, will miss the summit, and a visit by "troika" inspectors representing the country's international creditors due this week has been postponed.
The German spokesman said no decisions would be taken on Greece at the summit as the "troika" inspectors from the European Commission, ECB and the International Monetary Fund must first assess Greek compliance with its 130 billion euro bailout agreement before any renegotiation could be considered.
The Samaras government, which was sworn in last week, has called for the renegotiation of the terms of Greece's bailout, which is keeping the country from bankruptcy but at the cost of great economic suffering.
The euro zone has set up two rescue funds to try to contain the crisis, the temporary EFSF and the permanent ESM, due to come into force next month, but markets have so far judged that they contain too little money and their rules are too inflexible to be effective.
(Additional reporting by Michelle Martin and Stephen Brown in Berlin, Catherine Bremer in Paris, Fiona Ortiz in Madrid, Luke Baker and Jan Strupczewski in Brussels; Writing by Paul Taylor; editing by David Stamp)