EU leaders must find a convincing solution to Greece's debt crisis at a summit on Thursday or the global economy will pay the price, the head of the European Commission said in an unusually somber warning.

Jose Manuel Barroso delivered the message as officials of the 17-nation currency area and bankers struggled to pin down a package of measures to persuade markets Greece can be saved from default and the rest of the euro zone from contagion.

Nobody should be under any illusion: the situation is very serious. It requires a response, otherwise the negative consequences will be felt in all corners of Europe and beyond, Barroso told a news conference.

He said the elements of a solution must include: measures to ensure the sustainability of Greek public finances, private sector involvement in funding for Athens, more flexible use of the euro zone's EFSF bailout fund, repair of the region's banking system and liquidity to keep the economy going.

In what sounded like veiled criticism of German Chancellor Angela Merkel, Europe's reluctant paymaster, Barroso said it was time for leaders to say what they can do and what they want to do. Not what they can't do and won't do.

Merkel lowered expectations on Tuesday, saying the summit would not bring a spectacular one-shot solution to the Greek crisis but only the latest in a series of incremental steps to tackle the roots of Athens' debt and competitiveness problems.

Christine Lagarde will attend the summit on behalf of the International Monetary Fund, which has told euro zone leaders that they should put more money into the EFSF bailout fund and allow it to buy government bonds on the secondary market.

The euro and peripheral euro zone bonds rose on hopes that policymakers would heed the IMF's advice on bond purchases and provide precautionary credit lines to countries in difficulty.

BANKS' PROPOSAL

However, Germany has so far blocked either course, and while a source close to the talks told Reuters earlier this week that both ideas were back on the table, there is no sign yet that Berlin has changed its mind.

Both would require changes in the EFSF's rules that would have to be ratified by national parliaments, and could fall foul of skeptics in Germany, the Netherlands and Finland.

They would also run counter to a treaty signed just three weeks ago creating a permanent crisis-resolution mechanism from 2013, the ESM, which would not have such powers.

Major European banks and insurers were to send euro zone governments a complex proposal later on Wednesday for helping in a planned 115 billion euro second Greek bailout, industry sources said.

One banking source said the banks were offering a mixture of debt rollovers, maturity extensions and other measures worth roughly 40 billion euros over three years, but details have yet to be finalized.

Another source said negotiations were still fluid but key elements would be a large rollover of expiring bonds for up to 30 years on credit-enhanced terms, and probably a much smaller buyback by the Greek government of its own bonds on the secondary market with money lent by the EFSF.

Those options would almost certainly prompt credit ratings agencies to declare a selective default, putting the European Central Bank in an acute dilemma as to whether to carry out a threat to reject Greek bonds as collateral -- a move that would starve Greek banks of vital liquidity.

The banks are determined to fight a proposal for a tax on the financial sector to help pay for a second Greek rescue, which a euro zone working paper obtained by Reuters on Tuesday showed was seen as the least risky private sector contribution.

A senior EU source said governments seemed to be converging around the tax proposal despite its drawbacks.

We're heading for another sticking plaster deal, he said. We're in a crisis and there's panic. Sometimes panic can lead to action, but it can also lead to paralysis, and in this case it's more about paralysis.

Banking sources said a tax would unfairly penalize banks with no exposure to Greek debt and would inevitably give rise to legal challenges.

GERMAN RETICENCE

Merkel and French President Nicolas Sarkozy, who conferred by telephone on Tuesday, met in Berlin on Wednesday evening for what could be the decisive preparatory session before euro zone officials start thrashing out details on Thursday morning, just hours before the summit, which could run late into the night.

There were no plans for Merkel and Sarkozy to talk to reporters, officials said.

We are very confident that there will be a good and sensible solution, Merkel's spokesman said, stressing private sector participation remained a key German priority.

French Foreign Minister Alain Juppe also said he was sure we will find an accord, adding that contrary to media reports, there is a very broad convergence of views among euro zone capitals.

However, Paris signaled apparent frustration at Berlin's continued opposition to common euro zone bonds, a step which European Socialist leaders and many economists argue would provide a long-term solution to the debt crisis.

French government spokeswoman Valerie Pecresse said after a cabinet meeting that German reticence was the main obstacle to the idea of issuing joint euro bonds.

Despite Wednesday's cautious market optimism, many analysts fear the fifth European summit this year will produce half-measures that, at most, will buy a couple of months before pressure for a Greek debt restructuring becomes acute again.

(The) summit could provide the last chance for euro-zone policymakers to get a grip on the region's debt crisis, Capital Economics said in its daily market note.

Anything other than a very decisive response could see the situation become irretrievable.

The ECB kept up a drumbeat of pressure on euro zone leaders to avoid any step that could cause a selective Greek default.

ECB chief economist Juergen Stark said in a newspaper he hoped the leaders would stick to a previous commitment to avoid a selective default, because anything else would confuse markets.

(Additional reporting by Alex Chambers, Jessica Mortimer and Kirsten Donovan in London, Andreas Rinke and Stephen Brown in Berlin, Nick Vinocur in Paris; writing by Paul Taylor; editing by Janet McBride)

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