U.S. debt, euro zone crisis hit European shares

LONDON (Reuters) - European shares fell to a one-week closing low on Wednesday, led by banks, on concerns a stalemate in talks to cut the deficit in the United States could trigger a default or a downgrade in the country's credit rating.

Fears of contagion in the euro zone debt crisis also hit share prices.

Banks were the worst performers, with the STOXX Europe 600 Banks index .SX7P down 2.2 percent.

The index has lost 5 percent in the past three-days.

Although most think the United States will reach a debt deal, a downgrade of its top-notch credit rating is now a possibility and if the United States did default it would cause havoc across markets.

"Banks are under capitalized and the last thing they need is the United States to default," said Louise Cooper markets analyst at BGC Partners. "When economies have been weakening, it is not a good time to create uncertainty in the United States."

Disappointing earnings hit Banco Santander SA (SAN.MC), down 3.2 percent, making it a stand-out loser, hurt by lower than expected first-half results and a 620 million euro charge to cover compensation for mis-sold payment protection insurance policies (PPI) in Britain.

Also affecting the banking sector were worries over the euro zone debt crisis and the possibility it might spread to other countries such as Spain and Italy.

Italian government bond yields rose after a letter obtained by Reuters showed that German Finance Minister Wolfgang Schaeuble said Berlin was against a carte blanche for secondary bond market purchases by the euro zone's rescue fund.

ITALIAN BANKS HIT

Italian banks, whose performance is highly correlated to the country's bond yields, were among the worst performing in the sector, with Intesa Sanpaolo (ISP.MI) and UniCredit (CRDI.MI) down 5.1 percent and 4.3 percent, respectively.

Broker Nomura downgraded its earnings estimates and price targets on Italian banks and said revenues would be hit as sovereign bond spreads widened.

"Recent regulatory pressure to shore up liquidity ratios and capital has had an impact on profitability, but Italian banks need a change of direction to NII (net interest income) to attract interest," Nomura said in a note.

"This is unlikely in the short term as sovereign issues are pushing up the cost of funding. The recent business plans also disappointed as they did not sufficiently address the cost base, confirming its structural inflexibility."

Adding to the concerns about banks was a Goldman Sachs downgrade on the sector to "neutral" from "overweight" on doubts about the role of the European Financial Stability Facility in the second Greece bailout.

The worries about Europe debt crisis spreading could be seen

in a fall in the Italian FTSE MIB .FTMIB down 2.8 percent, while Portugal's PSI 20 .PSI20 fell 2.7 percent and Spain's IBEX .IBEX slipped 1.9 percent.

A Reuters poll of economists showed that the latest rescue package for Greece was only a step in the right direct and not a turning point in the euro zone debt crisis.

The pan-European FTSEurofirst 300 .FTEU3 index of top shares closed down 1.1 percent at 1,088.73 points and having extended losses on weak U.S. June durable goods data, and then again after the Wall Street open.

Investors' appetite for risk fell, with the Euro STOXX 50 volatility index .V2TX, Europe's main fear gauge rising 8.3 percent. The higher the volatility index, the lower investor appetite for risk.

Another stand out loser was French car maker PSA Peugeot Citroen (PEUP.PA), down 7.6 percent in volumes nearly four-fold its 90-day daily average after Europe's second-largest car maker warned 2011 profitability in its automobile division would be hit by raw material costs.

(Reporting by Joanne Frearson. Editing by Jane Merriman)