WRAPUP 3-Trichet warns of econ strains as bailout talk simmers
* Trichet says global financial system under severe strain
* Almunia says bailout of EU member can't be ruled out
* Gonzalez-Paramo also warns of risk of solvency
(Adds Gonzalez-Paramo, Nowotny, Eastern Europe detail)
By Anna Willard and Huw Jones
PARIS, Feb 23 (Reuters) - The euro zone's financial system is under severe strain and hampering economic recovery but more extensive regulation would strengthen its defences, European Central Bank President Jean-Claude Trichet said on Monday.
He said the process of deleveraging -- selling assets to reduce debt -- across the banking system needed to be watched closely as there was a risk it could undermine the banking system entirely.
"The financial system of the euro area, as those of the other industrialised economies around the globe, is under severe strain," Trichet told a conference on regulation.
"What has become increasingly clear since the intensification of the crisis mid-September last year is that the strains in the financial sector are spilling over to the real economy."
He went on to say the crisis had highlighted substantial structural weaknesses and there was a need to regulate hedge funds, credit rating agencies, off-exchange traded derivatives and correct bank pay incentives that led to excessive short-termism.
His comments sparked a fall in the euro against sterling EURGBP= currency traders said, while speculation about the odds of a European Union member bailout also rattled markets.
Joaquin Almunia, the European economic and monetary affairs commissioner, told a conference in Madrid that it could not be ruled out that the European Union would have to bail out a member state in financial trouble. [ID:nLN547368]
Trichet added the financial sector's problems were hampering economic recovery at the same time as the recession was putting pressure on the financial system.
"This situation is more difficult to combat than if the problems had remained largely confined to the financial sector," he said.
