Spain's four nationalised banks will more than halve their balance sheets in five years, slash jobs and impose hefty losses on bondholders.
The measures are part of plans approved by the European Commission today.
They open the door for nearly €40 billion in euro zone bail-out funds for the state-rescued banks.
They also offer hope for an end to Spain's banking crisis which has pushed the country to the brink of asking for sovereign aid.
The approval sets in place one of the most far-reaching over-hauls of any European banking system ordered by the Commission since the start of a banking crisis in mid-2007 with the near collapse of German lender IKB.
"Our objective is to restore the viability of banks receiving aid so that they are able to function without public support in the future," said European Union Competition Commissioner Joaquin Almunia said.
Bankia, NCG Banco, Catalunya Banc and Banco de Valencia were taken over by the Spanish state after unsustainable lending during the country's decade-long property boom left the lenders dangerously short of capital.
The smallest of the four banks, Banco de Valencia, will be sold to one of Spain's healthiest lenders Caixabank, while the other three banks must cut their balance sheets by more than 60% over the next five years.
It was cheaper to sell Banco de Valencia under a loss protection scheme than to wind it down, the Commission said. Spain will sell NCG Banco and Catalunya Banc within five years or liquidate them.
Almunia said the nationalised banks would have to close up to half their branches during the five-year overhaul process.
The biggest of the banks, Bankia, said it would lay off over a quarter of its workforce amounting to over 6,000 staff, reduce its branch network by around 39% and aim to return to profitability by 2013.
Bankia, formed from the merger of seven savings banks in 2010, said holders of hybrid debt would contribute up to €4.8 billion to the recapitalisation, through losses incurred by swapping their holdings for shares.
The European Commission said the cost to hybrid and subordinated bondholders in the restructuring of the nationalised banks will come to about €10 billion. Many hybrid debt holders at the nationalised banks are retail customers who say they were conned into buying complex financial instruments that buoyed banks' capital levels instead of fixed-term savings accounts.
The Commission said it would ensure the banks use no more taxpayers' money than necessary and that they do not go back to unsustainable business practices. The Commissioner said he would decide on other Spanish banks with capital shortfalls on December 20.
The approval allows the euro zone to disburse the funds from its permanent ESM bailout fund. Spain was given approval to receive up to €100 billion from the ESM in the summer.