WASHINGTON (Reuters) - The International Monetary Fund urged the European Union to quickly set up an agency that would close or salvage troubled banks across the continent as part of an effort to shed a mountain of bad debt impeding economic recovery.
The recommendation - one of a long list to address structural faults in the world economy - comes as European Union lawyers raised concerns about the plan to set up a so-called banking union.
Banks in euro-zone countries hit hardest by the debt crisis were forced to raise interest rates on risky loans to clients who had difficulty paying already, further worsening the chance they would get their money back, the IMF said.
"Investors' faith in euro-area bank balance sheets must be restored ... and banking union completed," the IMF said in its Global Financial Stability Report on Wednesday.
"Otherwise, the euro area risks entering a lengthy, chronic phase of low growth and balance sheet strains," it said in the report, which comes out twice a year.
The EU should also conduct rigorous probes - so-called stress tests - into the health of its banking sector, the IMF said, and identify ahead of time who would fill any capital shortfalls, in order to lend the exercise more credibility.
The EU will take the first step towards the banking union next year, when the European Central Bank takes on supervision of banks throughout the euro zone, something that is now divided between dozens of national agencies.
But the IMF said a second pillar of the project - the creation of an agency to close troubled banks and a central fund to help pay for the costs of the clean-up, or Single Resolution Mechanism - was equally essential.
"(The current situation) places the burden of raising capital firmly back on bank shareholders and creditors or on the sovereign ... or on both, and, thus, may not provide sufficient backstop," the IMF said in the report.
EU lawyers are concerned that setting up a framework that would break the link between indebted countries and their banks raises an array of political and legal complications, mainly about who would foot the bill.
The latter point is of particular concern to Germany, the euro zone's largest economy.
The IMF also said the EU should improve its insolvency laws and debt workout arrangements and help companies seek financing from sources other than bank loans - for instance through corporate debt markets.
In a test run, the IMF estimated that Spanish banks could face an estimated 104 billion euros ($141.40 billion) in losses on company exposure in the coming two years, though this amount is fully covered by loss provisions.
In Italy, the estimated gross loss could exceed the provisions by 53 billion euros, and in Portugal by 8 billion euros. In both cases, those losses could be absorbed from operating profits without eroding capital.
The IMF's report was a broad-ranging review of possible risks to a wide range of sectors in the global economy, with one key possible cause of disturbance being a retreat by the U.S. Federal Reserve from its easy monetary policy.
The shadow banking system - a loosely defined set of unregulated entities that function like banks - remained a potential source of systemic stress, the IMF said, as did the so-called repo market, which is part of it.
The IMF singled out mortgage real estate investment trusts (REITs) as one particular cause of concern, being prone to asset fire sales because they provide long-term debt that they fund in volatile short-term debt markets.
Reporting by Douwe Miedema; Editing by Paul Simao