(BRUSSELS) - The European Union took a historic leap towards greater integration just hours ahead of a summit on Thursday, with a deal on a banking union to prevent a re-run of the eurozone's recent crisis.

German Chancellor Angela Merkel, just beginning a fresh four-year mandate, will be closely watched at the summit for her response to the agreement, which marks one of the biggest transfers of national sovereignty to the EU since the creation of the single currency.

The deal is expected to bolster her pledge this week to build a stronger Europe, together with key partner France.

Invigorated by a third term as leader of Europe's biggest economy, she has also signalled her determination to push through unpopular reforms to ensure the financial stability of the 28-nation bloc.

But the austerity she is preaching has not gone down well in the eurozone.

Thousands of people angered at public spending cuts protested ahead of the summit, setting pallets on fire, hurling crackers at police and blocking key roads around EU headquarters ahead of the arrival of Europe's leaders.

"Rise up against austerity," said one banner.

Hours earlier, the EU's 28 member states sealed a landmark bank deal drawn up after collapsing banks drove countries such as Ireland into international bailouts and brought the economy to a halt.

The accord opens the way to create a single body to police and wind up ailing banks, backed up by a fund set up by banks themselves to cover the cost to avoid using taxpayers' money.

All 17 countries -- soon to be 18 -- sharing the single currency will be bound to the scheme while non-euro members have the option of joining.

French Finance Minister Pierre Moscovici called it "an accord that I believe is historic".

EU Financial Markets Commissioner Michel Barnier said: "We are producing revolutionary changes to Europe's banking system so that taxpayers will not foot the bill in banking crises, ending an era of massive bailouts."

Crucially, it will promote "financial stability ... so that banks can lend to the real economy" again, helping produce much-needed growth and jobs, he said.

With fragile growth of just 1.1 percent and a stubbornly high unemployment rate of 12.2 percent, the eurozone is badly in need of a confidence boost.

However, critics warn that the deal faces tough passage through the European Parliament, with the Socialist head of the institution Martin Schulz saying lawmakers feel that it is "very far from" expectations.

Make Europe a strong continent

Merkel set the stage for the summit with a pledge to strengthen Europe, alongside France.

"Together, we want to push Europe forward and make it a strong continent in the world," said Merkel late on Wednesday after a meeting with French President Francois Hollande in Paris.

To do so, she signalled she would press through change as necessary.

"We are among those who say that we must, if treaties are no longer sufficient, develop those treaties ... Those who want more Europe must be ready for new rules on some competencies," she told the Bundestag lower house of parliament on Wednesday.

Key among reforms championed by Germany is more centralised financial and economic governance, with EU members compelled to meet certain fiscal targets, even if this requires treaty changes.

Hollande has pushed instead for more pro-growth policies and less austerity within the existing European charters.

Beyond economic matters, the summit, which is nominally dedicated to defence issues, will also examine the crises in Syria and the Central African Republic.

Another issue is the EU-Russia tug-of-war over Ukraine, where tens of thousands of people have descended on the streets to protest Kiev's decision to ditch a trade deal with the bloc, turning instead to Russia to rescue its economy.

EU sources said the leaders were expected to issue a message of empathy with the people of Ukraine while reiterating the bloc's readiness to sign a partnership deal with the former Soviet state once it feels ready.

But earlier on Thursday, Ukraine's President Viktor Yanukovych told Western powers to stay out of his country's political crisis, even if he said that Kiev's deal with Moscow did not contravene its path towards EU integration.

3281st ECONOMIC and FINANCIAL AFFAIRS Council meeting (continuation) - Brussels, 18 December 2013 (provisional version)