Europe's banks are facing more government-prescribed mergers and further measures to strengthen capital, as the region's inability to end its debt crisis makes investors wary of shoveling more money into lenders.

Politicians may also quietly be urging banks to carve out toxic assets into separate units -- known as bad banks -- and present the healthy remainder to money managers, investment bankers working in the sector said.

It won't happen in a prescriptive way. But in a factual way it is happening. It is not like they put a gun to your head. But we're part of the system, so yes, you pick up the phone, said one senior investment banker.

A European Union official told Reuters on Tuesday that finance ministry officials will discuss how governments can inject capital into struggling banks.

The discussion follows a meeting on Monday among euro zone officials that examined progress in involving private investors in Greece's second international bail-out. There are growing concerns further market turmoil will follow if not enough bondholders participate.

European bank shares have lost value at pace this year, as the euro zone struggles to escape the threat of sovereign default, sending risk premia soaring and hurting the value of banks' massive bond holdings.

With no swift solution in sight for the 17-country bloc's debt crisis, investors are unwilling to bet their money on banks and plug a capital hole left behind by tighter regulation and years of anemic income.

Tell me one reason why a rational investor should put money in a bank rather than a pharma company, said another investment banker, who advises financial institutions.

Politicians can run around as much as they want telling investors to recapitalize the sector, but unless they get their house in order the only last resort for the banking sector will be the tax payer, the banker said.

European bank shares <.SX7P> are trading at levels first reached in 1993. They have lost more than 40 percent from a February peak, and are at their lowest since a 2009 trough hit in the wake of the collapse of Lehman Brothers.

Some of Europe's weaker banks now rely on European Central Bank funding, having been locked out of money markets as their rivals hesitate to lend them short-term unsecured money because of concerns over their ability to repay.

DEALS NUDGE

Tying up with a stronger rival allows weaker banks to raise market share, making them more attractive for investors because of better access to depositor funding, and lessening the risk that any government would let them go under.

The recent merger between Greece's Alpha Bank and EFG Eurobank -- backed by a Qatari capital injection -- suggested that governments may now be promoting such deals, which had virtually ground to a halt in the crisis.

I have to assume (the Qataris) have spent time with politicians doing due diligence on the political and macroeconomic context, the second banker said.

This is not just putting money in a bank, this is putting money in Greece. And therefore I have to believe they are comfortable with that, the banker added.

EFG Eurobank was one of only eight banks to flunk Europe's stress tests -- an annual health check -- and other banks that failed the test, or just scraped through, could face a similar fate, and be taken over.

Greece should also consider separating banks' non-performing loans from good assets into a bad bank, if its financial sector is not able to attract outside investors, a consultant with experience of bad banks said.

What is likely to happen ... is a repeat of the Irish model. It's a process that should happen hand in hand with the stress tests, and which could help attract investment, said the consultant, who now advises banks.

Ireland's state-run bad bank, the National Asset Management Agency, is one of the world's largest property groups after bailing out banks of assets they were stuck with. Germany and the UK have set up bad banks on a smaller scale.

Such measures stop short of the 200 billion euros ($284 billion) mandatory recapitalization that International Monetary Fund head Christine Lagarde said Europe's banks needed last month, higher than official estimates.

Banks scorned the idea, with Deutsche Bank chief executive Josef Ackermann saying on Monday the idea would threaten to send the signal that politics has lost faith in the ability of existing measures to succeed.

(Additional reporting by Sarah White and Kylie MacLellan; editing by Sophie Walker)

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