Banks, commods lead FTSE down for 3rd straight day

* Financials fall as sentiment dips

* Energy stocks down on softer commodity prices

* U.S. defence budget boosts defence stocks

By Dominic Lau

LONDON, April 7 (Reuters) - Britain's leading share index lost 1.6 percent on Tuesday, falling for the third straight session, as banks declined on renewed caution on the outlook for the financial sector while oil producers tracked softer crude.

The FTSE 100 .FTSE closed 63.02 points lower at 3,930.52, after losing 0.9 percent on Monday. The index is down more than 11 percent for the year, after tumbling more than 31 percent in 2008.

Volumes on the FTSE 100 were at 87 percent of the index's 90-day average daily volume in a shortened trading week because of the Easter holiday.

"The strength in the market over the past month has basically been a bear market rally, a sequeeze caused by slightly less bad economic data releases over the latter part of winter and the early part of spring," said Jeremy Batstone-Carr, head of private client research at Charles Stanley.

"The key is that real economic conditions are only slightly less bad than the turn of the year rather than actually showing clear sign of recovery."

Banks were among the standout losers. Lloyds Banking Group (LLOY.L) sagged 8.5 percent after Credit Suisse downgraded it to "underperform" from "neutral".

Standard Chartered (STAN.L) dropped 6.3 percent after UBS downgraded the Asia-focused lender to "sell" from "neutral" after it said an 80 percent rise in the stock in a month had left the bank "ahead of itself".

HSBC (HSBA.L), Royal Bank of Scotland (RBS.L), which said it planned to shed up to 9,000 jobs over the next two years, and Barclays (BARC.L) lost between 1.9 and 10.4 percent.

Calyon analyst Mike Mayo recommended to investors on Monday that they reduce or sell holdings of several large U.S. bank stocks, citing the ongoing consequences of risk taking by banks in several different areas.

Gloom in the financial sector also weighed on insurers, with Legal & General (LGEN.L) down 6.9 percent, Aviva (AV.L) off 4.8 percent and Prudential (PRU.L) losing 5.3 percent.

"We remain underweight on L&G as it is most exposed to bank hybrid debt and default assumptions," JPMorgan said in a note. "Aviva has a smaller exposure 1.2 billion pounds, but much more lower Tier 2 capital on its own balance sheet, which could end up being disregarded for solvency."

British manufacturing output fell less than expected in February but still saw the 12th straigt month of declines.

Heavyweight oil producers were another drag on the UK benchmark, as crude prices CLc1 eased. BP (BP.L), Royal Dutch Shell (RDSa.L), BG Group (BG.L) and Cairn Energy (CNE.L) were off 1.7 to 4.3 percent.

Miners also retreated, with Rio Tinto (RIO.L), BHP Billiton (BLT.L), Kazakhmys (KAZ.L), Vedanta Resources (VED.L), Anglo American (AAL.L) and Lonmin (LMI.L) falling 1.9 to 6.4 percent.

Defence companies benefited as traders said a U.S. overhaul of the world's most powerful military arsenal would not lead to spending cuts as significant as some in the sector had feared.

BAE Systems (BAES.L) surged 5.8 percent to top the FTSE 100 gainers' list, with analysts saying it was benefiting as the budget unveiled bigger funding for the F-35 joint strike fighter jet, which it part builds, while peer Cobham (COB.L) put on 2.2 percent.

Food producers, seen as a relatively safe bet in falling markets, were higher. Cadbury CBRY.L and Unilever (ULVR.L) gained 2.4 to 3.2 percent, respectively. (Additional reporting by Simon Falush; Editing by David Cowell)