* Portugal's PSI share index falls 4.2 percent
* FTSEurofirst 300 index closes 1 pct lower
* European banking index among top fallers
By Atul Prakash
LONDON, July 10 (Reuters) - Investors across Europe trimmed their exposure to banks on Thursday in response to growing concerns about the health of Portugal's biggest listed lender, with a leading pan-European share index slipping to a two-month low.
Portugal's PSI share index fell 4.2 percent to a nine-month low, lagging all other European benchmarks, after shares and bonds of Espirito Santo Financial Group, the chief shareholder in Banco Espirito Santo, were suspended over "material difficulties" at its parent firm ESI.
Trading in Banco Espirito Santo was also later halted after a 19 percent drop, making investors nervous across Europe. The FTSEurofirst 300 index of top European shares closed 1 percent lower at 1,349.89 points after falling as low as 1,342.68, the lowest since early May.
Financial stocks bore the brunt of the sell-off, with the STOXX Europe 600 Banking Index falling 1.7 percent to its lowest level since the middle of December.
"The BES situation is a tangled story of cross holdings and unexplained debts which has highlighted the risks that still exist in some European banks," said Lorne Baring, managing director of B Capital Wealth Management.
"There is some contagion effect in markets today. However, it may be an over-reaction to the BES news ... Some investors may be questioning the strength of the peripheral Europe recovery after a strong market performance."
Concerns about the country's financial sector pushed Portugal's 10-year bond yields above 4 percent as they revived memories of the country's debt crisis, which forced it to seek a bailout in 2011.
Other markets were also under pressure. Italy's FTSE MIB fell 1.4 percent after data showed Italian industrial output in May posted its steepest monthly fall since November 2012, casting doubts over its economic recovery, while Germany's DAX index fell 1.5 percent.
"The risk of contagion is clearly visible in the markets today as the market fears that there is more to come," said Philippe Gijsels, head of research at BNP Paribas Fortis Global Markets in Brussels, referring to the problems at ESI.
"I would treat it as an isolated case at the moment, but I would not be a buyer today and tomorrow as I think this can be a story for a while."
The Euro STOXX 50 Volatility index, Europe's widely used gauge of investor sentiment based on put and call options on Euro STOXX 50 stocks hit a two-month high before closing 10 percent higher, signalling a rise in risk aversion.
Spanish stocks fell 2 percent, pressured by a 2 percent drop in Banco Popular Espanol and a 1.8 percent fall in ACS after the companies postponed their bond issues, citing unfavourable market conditions.
Nordic stocks weakened following disappointing updates from DNB and Swedish construction firm Skanska.
DNB, Norway's largest bank, posted lower-than-expected second-quarter results, partly due to higher loan losses, while Skanska said it would significantly scale down its loss-making Latin American operations. Their shares were down 5 percent and 2.5 percent respectively.
Luxury group Burberry bucked the trend by rising 3.2 percent, the top gainer on the FTSEurofirst 300 index, after a 12 percent rise in like-for-like retail sales in its first quarter to June 30. But it warned that if exchange rates remained at today's levels, that would have a "material impact on profits".
"Despite driving best-in-class top-line growth, the continued margin pressure at Burberry remains a concern, and today's results do not help to improve the profitability gap that exists between Burberry and its luxury peers," Bernstein analysts said in a note.
Europe bourses in 2014: link.reuters.com/pap87v
Asset performance in 2014: link.reuters.com/gap87v
Today's European research round-up (Additional reporting by Francesco Canepa; Editing by Catherine Evans)