UPDATE 1-Weakened German banks may exacerbate credit crunch

* High grade loan margins rise to 155 basis pts in Q1 2010

* KfW sees credit crunch danger from lack of loan supply

* Insolvencies among midsized companies up 16 pct in 2009

(Adds context, background)

FRANKFURT, April 12 (Reuters) - The weakness of the German banking sector may exacerbate a credit crunch, Germany's KfW said on Monday, in a sign that the fallout of the financial crisis continues to be a threat to the real economy.

Germany's banks emerged from the deepest post-war recession, buoyed by fiscal stimulus measures that helped many of them continue paying eye-popping bonuses even as the real economy struggles with slumping demand and a higher cost of borrowing.

Frankfurt-based KfW, controlled by the German government and federal states, said loan volumes declined over the past year, reaching an "extraordinarily weak" level in the fourth quarter of 2009, even taking into account the weaker economy.

"One could conclude that the issuance of loans was further slowed also by an insufficient capital levels among banks," KfW said, adding the fall is no longer attributable purely to a fall in demand for loans among German companies.

Economists and industry leaders fear the real economy's performance may be stifled this year by a prohibitive rise in the cost of loans, especially to the small to mid-size firms -- referred to in Germany as the "Mittelstand".

Average high-grade loan margins in Germany jumped to 155 basis points in the first quarter 2010 from 60.40 basis points in the first quarter 2006, mirroring a similar rise in the price of loans across Europe, data supplied by Thomson Reuters show.

The weak capital situation at German banks, the threat of further writedowns and rating downgrades could inhibit banks' ability to extend loans, KfW said.

Citing a survey of German companies, KfW said it, "sees a danger of an exacerbation of the problems supplying credit for 2010."

A Fitch survey on European bank lending, published in February, said business failures reached record levels in 2009 and that banks may be starving the real economy of essential funding.

Indeed, the number of insolvencies among German Mittelstand companies in 2009 rose by 16 percent to 34,300, compared with 2008, according to German credit risk data provider Creditreform. Insolvencies are set to rise further in 2010, it said.

The rise in insolvencies comes as Germany's troubled banking sector seeks to reshape itself in the wake of the financial crisis.

Public-sector and private banks are cutting down the size of their balance sheets and shedding core businesses in response.

In 2009 alone, Germany's largest lender Deutsche Bank (DBKGn.DE) cut its balance sheet by a third, and Commerzbank (CBKG.DE), the second-largest, cut assets by 19 percent.

German banks have started introducing initiatives to help prop up firms' finances amid criticism that they lend too little to Mittelstand companies pummelled by the financial crisis.

Deutsche Bank launched a 300 million euro ($408 million) fund for the Mittelstand, while Commerzbank said it would make an additional 5 billion euros available for loans to mid-sized companies and appointed an ombudsman to oversee appeals against loan rejections. [ID:nLDE6192CA] ($1=.7355 Euro) (Reporting by Edward Taylor; Editing by Jon Loades-Carter)