Any deal forcing banks to take bigger losses on Greek debt "would be tantamount to default" and impose a high cost on European taxpayers, the lead negotiator for the banks warned on Monday.
Banks and other private sector holders of Greek government bonds have been holding talks with EU officials to revise a plan agreed in July and take bigger losses on the debt, but Charles Dallara, managing director of the Institute of International Finance (IIF), warned against pushing too hard.
"There are limits ... to what could be considered as voluntary to the investor base and to broader market participants," said Dallara.
"Any approach that is not based on cooperative discussions and involves unilateral actions would be tantamount to default, would isolate the Greek economy from international capital markets for many years, and would impose a harsh burden on the Greek people as well as European taxpayers who have already done a lot to support Greece," he said in a statement.
EU leaders on Sunday outlined plans to recapitalize and improve funding for European banks, but failed to resolve how big a loss the private sector takes on Greek bonds and how to make best use of the EFSF euro zonerescue fund.
Banks have offered to stretch the voluntary loss on Greek debt to 40 percent, from July's agreement to take a 21 percent loss, but politicians are demanding the private sector agree to writedowns of at least 50 percent, a senior German banker said. Banks fear that too big a "haircut" will set a dangerous precedent, particularly for Italian bonds.
Private sector investors hold 206 billion euros of Greek government bonds, and losses of 50-60 percent are needed to make Greece's debt sustainable in the long term, a study said.
Dallara said the IIF continued to explore options that can help renewed growth and investment in Greece, while preserving the voluntary approach.
Investors are keen for details to emerge from a second summit of European leaders on Wednesday.
Officials on Sunday endorsed a broad framework for recapitalizing banks by between 100 billion and 110 billion euros ($139-152 billion) to cope with likely losses on Greek and other euro zone sovereign bonds.
The recapitalization plan aided bank shares but would be worthless without a wider debt crisis solution, analysts said.
"Even if we'd got 200 billion euros in or 300 billion euros, the recapitalization is just part of a bigger picture. Unless the market becomes convinced that there's a mechanism to support Italy, even a multiple of this capital wouldn't be enough to bring reassurance," said Jon Peace, bank analyst at Nomura.
The STOXX 600 European bank index rose 1.7 percent on Monday, outperforming a 1.1 percent rise by the broader pan-European index.
A breakdown of how much individual banks need is due to be released on Wednesday. The bulk of the capital is likely to be needed by banks in Greece, Spain and Portugal.
France's Societe Generale and BNP Paribas, Germany's Deutsche Bank and Commerzbank and Italy's UniCredit could each need several billion euros, according to estimates by Reuters and analysts. Spain's Santander and BBVA could also need to plump up their capital, some analysts estimate.
Most of the major listed banks should be able to raise what they need privately, bankers and analysts said. But depressed valuations -- the sector is trading at 0.6 times book value -- will make it painful to raise funds privately.
Retained earnings should help banks that need cash, and lenders could accelerate the disposal of assets and the restructuring of their business models.
Scrapping dividends for this year and next at the banks that need capital could save 32 billion euros, analysts at Credit Suisse estimated.
Bank of France Governor Christian Noyer said French banks would need less than 10 billion euros, despite their high exposure to Greece and other peripheral euro zone nations.
Germany's banking association said a shortfall of about 5.5 billion euros is being mooted by regulators for its banks.
But Greek bank shares tumbled 17 percent on fears that a deeper markdown on Greek bonds would force lenders to be part-nationalized. Greece's banks could need more than 30 billion euros in new capital.
Greece wants a solution to apply to all its sovereign bonds expiring up to 2035, which should be voluntary, a government source said. Greek banks would remain in private hands and would not be nationalized, the source said.
Under the recapitalization plan, banks will need to hold core capital of 9 percent of risk-weighted assets after marking sovereign bonds to market prices. Banks are expected to be given six to nine months to raise money, first from their earnings or private investors, then by getting national bailouts or as a last resort from the EFSF.
($1 = 0.720 Euros)