By John O'Donnell and Jan Strupczewski
The warning, delivered by Jose Manuel Barroso, President of the European Commission, is intended to galvanize France and Germany, the bloc's main powers, into action when they meet on October 23 under international pressure to limit the damage the debt crisis risks inflicting on the world economy.
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"Doubts and uncertainties over Greece's future jeopardize stability in the entire euro area and beyond," said Barroso. "The time has come to remove these doubts."
Although he has no power to introduce such measures himself, his view is influential and keeps pressure on German Chancellor Angela Merkel and French President Nicolas Sarkozy who have promised a deal to stabilize the euro zone this month.
A key part of that plan will be to strengthen banks against losses on Greek loans. Officials said on Wednesday that countries will ask banks to accept losses of up to 50 percent -- far more than the 21 percent proposed in July.
But Europe's banks need protection, in the form of extra capital, from the fallout of such a move.
Central to Barroso's proposal, which needs the backing of EU member states, is the early introduction of the European Stability Mechanism (ESM) to replace the temporary EFSF bailout scheme by mid-2012 -- an idea originally put forward by Germany.
The 500 billion euro ($690 billion) permanent fund would have a solid base of paid-in capital and power to intervene on markets to help struggling states.
It would also introduce the first European framework for coping with countries that default on their debt, a step some investors worry could herald even steeper losses.
"Despite assurances... to support countries under programs and... that private sector involvement would be strictly limited to Greece, contagion has not been contained," Barroso said.
Barroso also pushed for bolstering the strength of the current European Financial Stability Facility (EFSF), a vehicle borrowing money with the backing of euro zone guarantees and lending it on to struggling countries such as Ireland.
"The EFSF must be more than a firewall, it must have real firepower. We must maximize its capacity."
Barroso said there should be a coordinated approach to strengthen Europe's banks, subjecting them to a higher capital hurdle and taking full account of exposure to sovereign debt -- a tacit acknowledgement that steeper losses are possible.
Governments should help weak banks if investors cannot be found, Barroso said. If states are not able to step in, banks could get assistance from the EFSF bailout scheme, he said.
Steeper losses for bondholders and the connected question of recapitalizing lenders put France in particular in an uncomfortable position.
French banks have lent the most to Greek consumers and companies -- almost 42 billion euros of loans were outstanding in March, according to the Bank for International Settlements, which tracks international lending -- and a further 13 billion euros to the Greek public sector.
German banks have total exposure less than half that of their French counterparts.
(Reporting by Jan Strupczewski and John O'Donnell; editing by Rex Merrifield, Sebastian Moffett and Ruth Pitchford)