By John O'Donnell and Ilona Wissenbach
LUXEMBOURG (Reuters) - European finance ministers agreed on Tuesday to safeguard their banks as doubts grew about whether a planned second bailout package for debt-laden Greece would go ahead.
Hours earlier French-Belgian municipal lender Dexia SA became the first European bank to have to be bailed out due to the euro zone's sovereign debt crisis.
"Everyone said the big concern is that worrying developments on the financial markets will escalate into a banking crisis," German Finance Minister Wolfgang Schaeuble told a news conference after EU ministers met in Luxembourg.
The growing prospect of a debt default by Greece in the coming months has stoked fears of a major banking crisis in Europe that would aggravate the global economic slowdown.
European Economic and Monetary Affairs Commissioner Olli Rehn told the Financial Times on Tuesday that the ministers, who have hitherto rejected any concerted bank recapitalization, had a new sense of urgency.
"There is an increasingly shared view that we need a concerted, co-ordinated approach in Europe while many of the elements are done in the member states," Rehn was quoted as saying. "Capital positions of European banks must be reinforced to provide additional safety margins and thus reduce uncertainty."
British finance minister George Osborne told reporters in Luxembourg he too had felt a sense of urgency among his euro zone colleagues.
"Euro zone banks need to be strengthened. We need to reflect the reality of the situation in the euro zone and we need to account for the reality of the sovereign risks which the market perceive out there. And that requires more capital in some euro zone banks," Osborne said.
Under the bail out for French Belgian lender Dexia announced on Tuesday, the lender will effectively be broken up, with the sale of healthier operations while toxic assets, including Greek and other peripheral euro zone government bonds, will be placed in a state-supported "bad bank.
Shares in Dexia, which had to be rescued a first time in 2008 because it had loaded up on toxic sub-prime debt, plunged by more than 22 percent on Tuesday.
After falling early in the day to levels not seen in more than 13 months, U.S. stocks recovered with the S&P500 index ending up 2.3 percent helped by the news that EU finance ministers were preparing action to safeguard their banks.
Earlier on Tuesday European bank shares tumbled for the second day, after euro zone finance ministers called for a review of a July 21 debt swap agreement with private holders of Greek bonds.
The euro hit a nine-month low against the U.S. dollar before recovering some ground, and hit a 10-year low against the yen. Investors sought refuge in German government bonds, but the cost of insuring even those safe-haven Bunds against default hit another record.
But after the New York markets closed on Tuesday, Moody's Investors Service cut Italy's bond ratings by three notches on Tuesday, saying it saw a "material increase" in funding risks for euro zone countries with high levels of debt.
The move came after Standard and Poor's cut its rating on Italy on September 19 and underlines growing investor uncertainty about the euro zone's third largest economy, which is now firmly at the center of the debt crisis.
MOMENT OF TRUTH
More and more European banks are being shut out of the market and relying on the European Central Bank for liquidity.
"The danger of escalation lies in the banking sector, as current events show," Schaeuble said, alluding also to tension in the inter-bank lending market with echoes of the freeze after the collapse of investment bank Lehman Brothers in 2008.
ECB President Jean-Claude Trichet warned in his final testimony to the European Parliament before retiring at the end of the month that the financial crisis is far from over and euro zone governments need to address it.
"I would say it is their responsibility to face up to the worst crisis since World War Two," the usually understated Frenchman said. "We are the epicenter of this global crisis."
Asked whether the ECB should act as Europe's lender of last resort, as the U.S. Fed and the Bank of England do in their countries, he pointed to its action in providing unlimited liquidity but said he did not favor bailout funds being refinanced by the central bank.
Schaeuble said the 27 EU ministers agreed to report by their next monthly meeting on the situation of banks in their countries and planned measures to protect them.
The decision came after euro zone ministers postponed a vital aid payment to Greece until mid-November and talked of reopening the private sector bond swap deal.
Greek Finance Minister Evangelos Venizelos said the country had enough cash to cope until then and insisted that ministers are not preparing for a Greek default, despite the ominous delay.
In Athens, striking public sector workers blockaded the entrance to several ministries on the second anniversary of the ruling Socialist party's election victory, disrupting talks with EU and IMF inspectors on the next aid tranche.
Analysts said the delay in disbursing the 8 billion euro Greek loan installment and the reopening of the bond swap increased the likelihood of a default once the currency area has its new financial firefighting tools in place.
Under the July deal, private creditors agreed to a 21 percent write-down on their Greek holdings via a plan to lighten and stretch the debt burden, with euro zone governments funding credit enhancements to attract voluntary participation.
"If they are having problems getting the sixth tranche of funding, what's going to happen to the seventh tranche of funding in three months' time? The situation is going to be even worse then. So Greece is on the brink," said Nick Stamenkovic, bond strategist at RIA Capital Markets.
Jean-Claude Juncker, chairman of the 17-nation Eurogroup, said ministers were considering "technical revisions" to private sector involvement in a planned 109 billion euro second rescue package which may now prove insufficient after Athens admitted it would miss key deficit targets.
Now that Greece's economic growth and deficit situation has worsened, that deal needed to be reviewed, Juncker said.
A senior euro zone source said banks might have to take a bigger write-down, and a bond buy-back scheme could be expanded, to achieve the same 50 billion euro private sector contribution as was agreed in July.
All roads now point to a mid-November crunch.
Euro zone parliaments are expected to complete approval of new powers for the EFSF rescue fund by mid-October, giving it scope to intervene on bond markets and help recapitalize banks.
Greece's admission on Sunday that it will miss its deficit target this year despite ever deeper cost-cutting measures provoked a sharp sell-off in stock markets and raised new doubts over the proposed second bailout.
Greece's draft budget sent to parliament on Monday showed this year's deficit would be 8.5 percent of gross domestic product, well above the 7.6 percent agreed in Greece's EU/IMF bailout program, the benchmark for future EU aid.
Compounding the debt problem, the economy is set to shrink by a further 2.5 percent next year after a record 5.5 percent contraction this year.
The deeper-than-forecast recession means public debt will be equivalent to 161.8 percent of GDP this year, rising to 172.7 percent next year, by far the highest ratio in Europe.
(Additional reporting by Annika Breidthardt, Jan Strupczewski and Philip Blenkinsop in Luxembourg, Ana Nicolaci da Costa and Neal Armstrong in London, Angeliki Koutantou, Ingrid Melander and Harry Papachristou in Athens,; Writing by Paul Taylor; editing by Janet McBride and Clive McKeef)