Dollar rallies as bank crisis spreads to Europe

NEW YORK (Reuters) - The euro and British pound tumbled against the dollar on Monday as bank nationalizations in Europe forced investors to calculate their risk exposure from financial instability that has now moved far beyond the United States.

A crisis in European banking threatened to overshadow the proposed $700 billion U.S. bank bailout deal that looked set for a vote in the House of Representatives on Monday. The plan would then be sent to the Senate for a vote.

The dollar did surrender some gains on Monday on an announcement by major central banks that they were throwing more resources at a deepening credit crisis, boosting U.S. dollar liquidity by expanding reciprocal currency swap arrangements to $620 billion from $290 billion.

News that Citigroup Inc will buy the banking operations of Wachovia Corp in a deal brokered by the Federal Deposit Insurance Corp added to market volatility.

"Investors are very concerned that there would be more weakness in the market and more bank failures to come, despite the latest central bank action," said Steven Butler, director of FX trading at Scotia Capital in Toronto. "So we're seeing the yen gain on this news."

Midway through the New York session, the euro had fallen 1.3 percent against the dollar to $1.4419, having earlier fallen more than 2 percent to a 10-day low at $1.4301 according to Reuters data.

The dollar's rally against the single European currency deepened as the Belgian, Dutch and Luxembourg governments nationalized parts of banking and insurance group Fortis (FOR.BR) and agreed to inject 11.2 billion euros into the financial group.

Sterling dropped to a 10-day low at $1.7962 after the government nationalized the lending business of Bradford & Bingley BB.L. Retail branches and deposits were sold to Spanish bank Santander (SAN.MC).

Sterling was last down 2 percent at $1.8082, its biggest one-day loss since December, 1996 at current prices.

Iceland's banking sector stress was highlighted as its government took control of Glitnir, its third-biggest bank GLB.IC.

Analysts said the latest developments snapped attention back to the international nature of the financial crisis, compared with a recent tendency to concentrate on the United States.

RESCUE PACKAGE

U.S. lawmakers geared up for a vote on Monday on creating the massive $700 billion government fund.

Congressional leaders from both parties said they had reached a tentative agreement on Sunday, but questions abound as to whether the rescue plan, which aims to use taxpayer funds to buy up illiquid mortgage debt, would restore confidence to shaky markets and head off a deeper downturn.

Federal Reserve Chairman Ben Bernanke said on Monday that the financial rescue plan should help restore the flow of credit needed to support the economy.

"Just how sustainable the dollar's rally will be may well depend on the speed of progress of the bill, but one thing that seems certain is that the greenback may well be on the front foot once more," said Gary Thomson, head of sales trading at CMC Markets in London.

Reflecting the dollar's broad rally, the high-yielding Australian and New Zealand dollars fell 2 and 0.8 percent respectively versus the U.S. currency, which also gained 0.3 percent against the safe-haven Swiss franc.

While the Swiss franc was depressed, aversion to risk boosted the low-yielding Japanese yen as share prices fell.

The euro slipped 2.4 percent to 151.16 yen while the dollar fell 1.1 percent to 104.86 yen.

(Additional reporting by Gertrude Chavez-Dreyfuss in New York and Veronica Brown in London, Editing by Chizu Nomiyama)