A Europe-wide test of the safety of its banks risks becoming a sideshow as long as politicians struggle to contain the continent's debt crisis and the detrimental impact on day-to-day funding for lenders.

Bankers say rapidly rising funding costs are a far bigger headache than Friday's release of the results of the annual probe by the European Union's banking watchdog, which is running the rule over 91 banks to see if they have sufficient capital.

The collapse of market confidence in sovereign debt affects banks more than any regulatory stress test, said an investment banker who advises financial institutions.

This is the markets stress-testing the system, which is far more dangerous than any simulation by a regulator.

Lack of clarity about how Europe plans to tackle the risk that countries such as Greece will default under a huge debt burden has sent bond yields soaring, dramatically raising the cost for banks when issuing new bonds.

The drop in bond values also means banks may need to write down any portfolios of sovereign bonds they hold. Bank shares have been losing ground as a result.

Depositor funding -- from clients who put their money in a current or a savings account -- is also under pressure, with withdrawals seen in countries such as Ireland and Greece and a fight for deposits in Spain and elsewhere squeezing margins.

And other funding channels -- such as the covered bond market, commercial paper, or asset-backed securities -- are also starting to look increasingly shaky.

Look at what's happening in Italy. The rates are going up 30 to 40 basis points a day. That's going to translate into a higher cost of funding, said a second investment banker, whose clients are also financial institutions.

Ten-year Italian bond yields jumped 40 basis points on Monday and briefly rose above 6 percent on Tuesday. They are now around 5.5 percent, more than 60 basis points higher than at the beginning of July.

The European bank share index has lost roughly 10 percent since the beginning of the month, as bankers and politicians frantically work on a plan to provide more support to Greece without triggering a default.

European finance ministers have acknowledged for the first time that some form of Greek default may be needed to cut Athens's debt, but investors fear that could ripple through Europe's banking system.

THE BIG ISSUE

European banks have raised about 43 billion euros ($61 billion) since their resilience against economic headwinds was tested last year, and this year will show the need for more capital.

This year isn't expected to throw up any surprises, either in terms of the numbers or the likely test failures.

A survey by Morgan Stanley in April estimated that fewer than 10 banks would fail the test, and that 30 to 40 billion euros of capital would be raised in the run-up to or after the exercise.

Unlisted banks in Spain and Germany and a batch of banks that are already raising new funds are the most likely to fail this year's tests, analysts at Nomura have said.

These are well identified today; there are some cajas in Spain, there are couple of regional banks. It's a very well-known sample of banks, the second banker said.

Nomura identified Spain's Bankinter and Sabadell, Italy's Banco Popolare, Greece's Piraeus and ATEbank, Cyprus-based Marfin Popular and Bank of Cyprus; and Bank of Ireland and Allied Irish Banks as vulnerable.

The EBA is also conducting a liquidity assessment, but its results will not be published. It is conducted in parallel with the stress test, and is used to inform supervisors about areas of funding vulnerability.

Given the uncertainty, the two bankers were telling their clients to hunker down. One said banks should sell as many non-performing loans and other toxic assets as possible to hedge funds.

We're recommending not to go out and do things that require more capital because it's unclear where the market will be. So it's safer to keep your ammunition and hope politicians get their act together, the other said.

(Additional reporting by Steve Slater; Editing by Will Waterman)

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