By Luke Baker
BRUSSELS (Reuters) - A tax on euro zone banks and cheaper, longer-dated official loans are the least risky way to provide extra funding for debt-stricken Greece, a confidential paper drafted ahead of a European summit showed on Tuesday.
With financial markets on edge two days before leaders of the 17-nation currency area hold a crucial meeting, other options that could trigger a selective or outright Greek default with far-reaching consequences remain on the table, the paper obtained by Reuters showed.
The European currency is facing the biggest crisis of its 12-year existence, with contagion threatening major economies such as Italy and Spain after three small members -- Greece, Ireland and Portugal -- needed financial rescues.
Euro zone leaders will try to agree on a second rescue package for Greece and a strategy to halt contagion when they meet in Brussels on Thursday, after senior officials thrash out detailed proposals in talks on Wednesday.
French European Affairs Minister Jean Leonetti confirmed late on Monday that euro zone officials were eyeing a bank tax to raise extra money to help Greece, which needs a further 115 billion euros in funding by mid-2014 on top of a 110-billion-euro EU/IMF bailout agreed last year.
"It's one of the solutions we are looking at. It would have the advantage of not making us intervene directly with the banks and therefore potentially not triggering a default," he told reporters in Brussels.
The tax idea "deserved to be studied," he said.
A source familiar with the talks said a small levy on banks could raise 10 billion euros a year, yielding the 30 billion euros over three years targeted by Germany, which has led the drive for private sector involvement in a new Greek program.
A tax would appear to have the drawback of lumping together banks that have an exposure to Greece and those that do not, but the source said it could be structured so that the main burden fell on those with Greek holdings. He did not say how.
A banking source and a national government official said the inclusion of a tax proposal was aimed at pressuring banks and insurers into agreeing on an acceptable form of voluntary private sector involvement in supporting Greece. Talks on this led by the International Institute of Finance, a banking lobby, were continuing in Rome on Tuesday.
"'If you don't come up with anything we can live with, we will impose a tax', is the threat that is hanging over the talks. This makes the negotiations even more difficult," one banking source said.
The options paper, dated July 16 but which officials said still reflects the wide open state of debate, showed that a tax on the financial sector was the only proposal deemed unlikely to cause a selective default. It identified three main options.
It suggested the levy could be combined with a commitment by Greek banks to roll over their big holdings of government debt, and by an extension of the maturity and a further reduction of the interest rate on euro zone loans to Athens.
The document gave no figure but officials have said they are considering extending the loans to 30 years and cutting the interest rate to 3.5 percent from the original 5.5 percent, which was reduced to 4.5 percent in March.
The European Central Bank has insisted that any solution must avoid causing a credit event, which would trigger a payout of default insurance, or a full or selective default.
ECB President Jean-Claude Trichet warned again this week that the central bank would not accept Greek government bonds as collateral to obtain liquidity in such circumstances, forcing euro zone governments to rescue Greek banks.
Another ECB policymaker, Ewald Nowotny of Austria, appeared to offer a glimmer of flexibility, saying a solution could depend on the duration of a selective default, but it was unclear whether he spoke for others on the central bank's governing council.
"There are some proposals that deal with a very short-lived selective default situation that would not really have major negative consequences," Nowotny told CNBC in an interview broadcast on Tuesday.
The euro zone paper said other options such as an EU-funded Greek government buy-back of its own debt on the secondary market, a German-proposed bond swap for longer maturities and a French plan for a voluntary rollover of maturing Greek debt would all generate additional costs for official lenders.
In those scenarios, euro zone governments would have to provide billions of euros to recapitalize Greek banks and provide them with collateral to obtain ECB funding, it showed.
A buy-back of Greek debt would do most to reduce Athens' debt mountain -- now close to 160 percent of annual economic output -- and make it more sustainable.
But it would also be the most costly option for the public purse, requiring billions of euros in additional euro zone loans on top of support for Greek banks and ECB collateral, the paper showed.
Another EU source said the outcome on Thursday was likely to be a mix of several options, with a bank tax, some form of debt swap and substantial extra loans to Greece from the euro zone's EFSF rescue fund.
Financial markets steadied on Tuesday but remained nervous. World stocks clawed back some recent losses, safe-haven German bonds fell on profit-taking and the euro regained some ground against the dollar.
Spain and Greece both sold short-term treasury bills, with the Greek three-month yield falling slightly but the Spanish 12- and 18-month yields rising sharply.
"Today's moves are not a sign of a sustained trend. It's just a bit of temporary respite after the sharp widening we saw in Italy and Spain yesterday," said Nick Stamenkovic, a strategist at RIA Capital Markets.
"Underlying sentiment remains pretty negative... ahead of the key EU meeting on Thursday," he said, predicting further downward pressure on Italy and Spain unless euro zone leaders achieved substantive progress.
(additional reporting by Philipp Halstrick in Frankfurt, Emilia Sithole-Matarise in London, Philip Blenkinsop and Jan Strupczewski in Brussels, Paul Carrel in Frankfurt, Gernot Heller in Berlin; writing by Paul Taylor; editing by Janet McBride)