The European Commission has said today that the euro zone should move towards a banking union and consider eurobonds.

It also has said it should consider eurobonds and the direct recapitalisation of banks from its permanent bailout fund as it laid out year-long recommendations.

The EU today published documents outlining the economic strategy for the euro zone.

It directly addressed market concerns about problems in the Spanish banking sector and the cost to the Spanish government of rescuing it.

Investors worry that public finances in Spain, which is already struggling to cut its large budget deficit at a time of recession, will become unsustainable if it is forced to bail out is banks, after a property market boom turned to collapse and left nearly all banks laden with bad property loans.

The Commission, the European Union's executive, said the vicious circle of weak banks and indebted sovereigns lending to each other needed be broken.

"A closer integration among the euro area countries in supervisory structures and practices, in cross-border crisis management and burden sharing, towards a "banking union", would be an important complement to the current structure" of Europe's economic and monetary union, the Commission said.

"In the same vein, to sever the link between banks and the sovereigns, direct recapitalisation by the ESM might be envisaged," the document said.

The euro zone's permanent bailout fund, the European Stability Mechanism (ESM), which comes into force in July, cannot as it stands lend directly to banks, only to sovereigns, even if only for the specific purpose of bank recapitalisation.

To change that, euro zone countries would have to change the treaty on which the ESM is based and which some euro zone countries have already ratified. Time is running short to do that, especially with the rapidly mounting problems in Spain.

Germany also strongly opposes allowing the ESM to directly recapitalise banks - an option Spain wants.

Focus on Spain

In a separate assessment of Spanish fiscal and reform plans, the Commission said that while Madrid has done much to help its banks, it had to tackle the remaining financial sector weakness.

"Recent reforms have helped to speed up restructuring of the banking sector, which should continue. However, ensuring the stability of the financial sector is still a challenge," the Commission said.

"Given the risk of bank-funding stress, it is necessary to continue to strengthen the banks' capital base."

"The reform measures adopted in February and May 2012 targeted the legacy stock of real estate assets, but the vulnerabilities related to other exposures such as loans to SMEs and residential mortgages have not been addressed," it said.

"Spain needs to ensure that the policy response is consistent with a broader strategic context (i.e. on-going discussions about new proposals for recapitalising of the financial sector across the euro area)," it said.

The Commission said Spain could try to raise additional revenues by getting more money from valued added tax, reducing tax breaks and raising excise duties on fuel. It has to cut spending on health care and pensions, among other areas.

France's deficit

The European Commission has warned France that hitting its deficit target of 3% of GDP by 2013 would prove difficult and urged it to do more to rein in public finances.

"Budgetary consolidation remains one of the main policy challenges in France," the commission said as it released report cards on euro zone economies.

"Although this year's target of 4.4 percent of GDP appears achievable, the distance to the three percent of GDP threshold remains significant," it said.

Euro zone firewall 

The European Commission said that consideration could be given to using the euro zone firewall, the European Stability Mechanism, to prop up Spanish and other crisis-hit banks.

"To sever the link between banks and the sovereigns (debt), direct recapitalisation by the ESM might be envisaged," the EU executive said in an annual report card on the 17-state eurozone and the economic challenges it must overcome.

As part of an annual analysis of all 27 EU states aimed at re-energising the combined economy of the debt-laden region, the Commission said there was a need to complete monetary and economic union with "a banking union."

The eurozone report said that "a closer integration among the euro area countries in supervisory structures and practices, in cross-border crisis management and burden sharing, towards a 'banking union' would be an important complement to the current structure" of the monetary union.

Spanish banks are in need of massive recapitalisation, a massive drain on the Spanish government's shrinking resources.

UK needs more houses 

The European Commission has urged Britain to build more houses. In the country specific recommendations issued today by the Commission, it calls on the UK authorities to implement a comprehensive housing reform to increase house supply, leading to lower housing costs and the level of state subsidy required for housing, which impacts on the state budget.