The report by the EU's economic and financial committee said that as the popularity of hedge funds with investors increased, so had their importance to financial stability.
Financial regulators have so far failed to fully appreciate the risks involved, it claims, with poor regulation of the US$1 trillion business.
"Hedge funds can contribute to market efficiency and sharing of risks, but can also be a source of systemic risks,' the report said.
"Action should be targeted to ensure efficient monitoring of hedge fund risks by banks... and the prudence... and transparency of regulated financial institutions' involvement in hedge fund activities."
The concerns come amid the increased exposure of banks to hedge funds, allowing potentially far-reaching consequences for financial stability should a large hedge fund collapse, as happened in 1998 with the collapse of US hedge fund Long Term Capital Management.
EU ministers hope to encourage EU states to set up contingency plans in order to deal with the potential risks, along with closer monitoring of the funds.