By John O'Donnell and Paul Carrel
BRUSSELS/BERLIN (Reuters) - European Union moves to shore up ailing banks moved into higher gear on Thursday and U.S. Treasury Secretary Timothy Geithner warned that the euro zone's sovereign debt crisis posed "significant risk" to global economic recovery.
The EU's executive arm said it would present a plan for member states to coordinate a recapitalization of their banks, as regulators met in London to reassess the capital buffers of stressed lenders that received a clean bill of health in July.
The European Central Bank threw a lifeline to commercial banks by turning up its liquidity pumps to provide longer-term cheap money for the growing number of European lenders which have seen wholesale funding dry up as market confidence ebbs.
The moves came amid growing fears that Greece, the most heavily indebted euro zone state, may be forced to default within months, setting off a chain reaction of sovereign downgrades and bank failures.
"We are now proposing member states to have a coordinated action to recapitalize banks and so to get rid of toxic assets they may have," European Commission President Jose Manuel Barroso said in a television interview relayed on YouTube.
It was the most explicit statement yet from a top European official on joint action to help restore confidence in a banking sector that is increasingly being shunned by investors as the euro zone debt crisis deepens.
However, a senior EU official told Reuters there would be no common European mechanism to deal with toxic assets, and no joint "bad bank" for Europe.
In the first case of a bank felled by the crisis, Franco-Belgian municipal lender Dexia's board will vote on a break-up plan on Saturday as the French and Belgian governments argue publicly over how to split the cost to the taxpayer.
Barroso would not speculate on how much money would be needed for recapitalization across the 27-nation bloc but his comments helped push European shares up one percent with investors welcoming the prospect of action.
The ECB disappointed some investors by leaving interest rates unchanged at 1.5 percent despite signs of a sharp slowdown in the European economy, but compensated with a raft of measures to boost liquidity.
ECB President Jean-Claude Trichet announced at his final monthly news conference before retiring that the ECB will provide unlimited one-year funding in two operations and revive its policy of buying covered bonds for up to 40 billion euros.
In Washington, Geithner said in testimony prepared for delivery to Congress that the United States was working closely with the International Monetary Fund to encourage European leaders to adopt a strategy to stabilize the situation.
While direct U.S. exposure to the crisis was quite small, because U.S. financial institutions had substantially reduced their exposure to the worst hit EU economies, Europe's integration with the world economy could cause significant damage, he said.
Some officials fear other lenders could suffer a similar fate to Dexia, even though they passed the European Banking Authority's (EBA) July stress test of 91 banks in the EU.
Those tests concluded that only eight banks failed and that they needed a collective 2.5 billion euros ($3.3 billion) -- a fraction of the up to 200 billion euros the International Monetary Fund believes EU banks require.
"Dexia is just one particular case, but we may have other particular cases that were not identified as being in a vulnerable position in July but because of the developments in sovereign debt markets may find themselves in that category," an EU official said.
The EBA, which set the criteria for the tests carried out by national regulators, was holding the second day of a board meeting to review banks' capital needs based on the same data which formed the basis of the July tests.
Finance ministers discussed the situation in Luxembourg on Monday but did not agree on any recapitalizing plan, the official added.
The EU's Competition Commissioner, Joaquin Almunia, said there was a need to reassess bank assets, especially sovereign debt to promote recapitalization, but taxpayer money should only be used as a last resort and in line with the bloc's state aid rules.
The EBA is preparing the technical ground by determining which lenders should be included in any coordinated recapitalization that its members would oversee.
The European Commission has no power to impose a recapitalization plan on EU states.
Markets and industry officials say the key missing piece is whether enough money can be found fast enough to fund a recapitalization plan and stop contagion from Greece or Dexia.
"The euro zone knows what it needs to do and should just get on with it," a UK banking industry official said.
The EBA, made up of regulators and central bankers from EU member states, said it was asked by the European Systemic Risk Board last month to "coordinate efforts to strengthen bank capital."
It is under heavy pressure after its chairman Andrea Enria admitted on Tuesday that this year's stress test, which Dexia passed with flying colours, failed to reassure investors.
A senior bank advisor said the EBA, as an internal exercise, may test banks twice a year to assess the impact of pricing their sovereign debt at the going rate, known as marking to market.
Some banks have come under heavy criticism for not updating investors clearly on the value of their government debt holdings and bumping up capital buffers to cover markdowns.
($1 = 0.751 Euros)
(Additional reporting by Dave Clarke and Rachelle Younglai in Washington, Huw Jones in London, Philip Blenkinsop and Jan Strupczewski in Brussels,; Writing by Paul Taylor, editing by Mike Peacock)