IMF: Debt threatens to engulf Europe

The IMF, run by Christine Lagarde, urges European leaders to quickly and decisively address the debt crisis.

NEW YORK (CNNMoney) -- The debt crisis engulfing Europe poses a significant risk to the global economy and the European Union must take decisive action to stop the spread of contagion, the International Monetary Fund said Tuesday.

In a review of euro zone financial policies, the IMF said the economic recovery is "solid" in most EU nations.

But the fund warned that unresolved fiscal problems in Greece, Ireland and Portugal could "spill over" into other nations and threaten the global economy.

"There was shared concern that the sovereign tensions could spill over into the core economies via the financial system with large adverse regional and global implications," the report states.

The report comes ahead of a key meeting in Brussels on Thursday. European leaders are set to hammer out the terms of a second bailout for Greece and discuss the intensifying debt crisis as it threatens to spread to Italy and Spain.

"The crisis in the periphery is not fully addressed yet," said Luc Everaert, a division chief in the IMF's European Department. "And the directors think this should be done very urgently."

European leaders "should not delay clarifying" the various proposals being discussed to address the crisis, said Everaert. The role that private sector investors will play, he said, "is a large uncertainty that has to be resolved."

Indeed, a key sticking point in the negotiations over Greece is whether banks would be forced to take losses as part of further bailouts of the debt-saddled nation.

In addition, the European Financial Stability Fund, the sovereign rescue program set up last year, should be expanded and modified so that it can be used as a more effective "backstop" for sovereign debt and banking problems, the IMF said.

The fund -- administered by the EU, ECB and IMF -- has the authority to issue up to 440 billion euros worth of bonds backed by EU members. It uses the proceeds to fund low-cost loans to troubled euro zone nations.

To date, the bailout fund has disbursed 9.5 billion euros to Ireland and Portugal. Greece received billions more before the fund was set up.

The fund is being scaled up to 500 billion euros, which should be "sufficient to address contagion," said Everaert. But authorities should be willing to increase the size if conditions in the euro zone deteriorate, he added.

To strengthen the financial system, the IMF called for "immediate measures" to ensure that European banks are sufficiently capitalized.

More stress for Spanish banks

The European Banking Authority said last week that eight banks will need 2.5 billion euros ($3.5 billion) to survive a serious downturn, and that 16 other lenders passed but should raise more money.

The debt crisis in Europe, which has been playing out for more than a year, has raised concern that the currency block is in danger of breaking up.

To address large structural problems, Everaert said the euro zone needs "binding rules" to ensure fiscal discipline across the 27-member group. He said the euro zone also needs to establish "backstops" for banks and governments to protect against future crisis.

But he sounded optimistic about the ability of European leaders to take needed steps to preserve the union.

"If we can contain the crisis to the periphery," he said. "Then we shouldn't have to worry about the others."