Fears about a possible global flu crisis and renewed worries over the capital health of some U.S. banks combined on Tuesday to rattle economists' hopes the financial system was stabilizing.

The Wall Street Journal reported regulators told Citigroup Inc and Bank of America Corp they needed to raise billions of dollars more in capital following stress tests of banks' ability to withstand the economic crisis.

The flu story and the story on Citi and Bank of America have spooked the whole market, CMC Markets analyst James Hughes said, talking about foreign exchange trading.

We will have to wait until the results of the stress tests on May 4 and it does raise fears because Citi and Bank of America are not necessarily the worst hit, he added.

The banks report emerged as markets factored in a rise in the World Health Organization's (WHO) pandemic alert to phase 4, pointing to a heightened risk of a global outbreak of Mexican swine flu.

This can be interpreted as a significant step toward pandemic influenza, but also it is a phase which says that we are not there yet, acting WHO Assistant Director-General Keiji Fukuda told a teleconference on Monday.

The U.S. banks report had the biggest impact on markets, with European stocks falling 2 percent, U.S. stock futures indicating a weak start on Wall Street and the yen rising to a seven-week high against the dollar.

In Tokyo, NTT SmartTrade director Takashi Kudo said: While most of the 19 banks that have been tested are expected to show less negative results, Citi and BofA seem to be in a shaky situation, prompting investors to pick up the yen on risk aversion as stocks fell.

CITIGROUP SHARES HIT

Neither Citigroup or Bank of America commented on the Wall Street Journal report, but Citigroup shares trading in Frankfurt were down 10 percent at 1100 GMT.

The U.S. Federal Reserve, which also declined to comment on the report, said last week the tests conducted at major banks were aimed at ensuring they had sufficient capital to continue lending in potentially worsening conditions.

The report had a chilling effect on hopes that recent economic news pointed to tentative signs of stabilization in the global economic crisis.

Other indicators indicated the mood of consumers and business was improving, but European banks were also hit by uncertainty.

UK retail sales jumped unexpectedly in April, figures from the Confederation of British Industry showed, the first positive showing since March last year. [nLS804880]

French consumer confidence improved marginally for the second month in April, while business confidence in Italy recovered more strongly than expected following 10 months of falls.

In Germany, data from some states indicated annual inflation probably accelerated slightly in April -- taken as a sign of firmer price pressures across Germany and the wider euro zone this month.

The broader global recession cast a cloud over Europe's banks as profits at Spain's BBVA slipped and key businesses at Deutsche Bank AG showed signs of strain.

Spain's second-largest bank unveiled a 14 percent dip in net profit in the first three months of the year as bad loans rose.

Germany's Deutsche Bank announced a loss in its wealth management arm, a dip in profit at its retail bank and 1.5 billion euros ($1.95 billion) of writedowns.

A windfall from debt trading helped the bank swing to a 1.2 billion euro first-quarter profit, however, which masked the erosion in key businesses.

GOVERNMENTS PREPARE FOR FLU

Governments around the world are bracing for a possible flu pandemic, although so far relatively few people have fallen ill outside Mexico where around 150 people have died.

This won't help sentiment, but for now, we're at the beginning of the outbreak and it's hard to anticipate the impact on the world economy, said Sebastien Barthelemi, analyst at Louis Capital Markets in Paris.

In the short term, airlines, hotel and oil companies are vulnerable, while drug companies could benefit from the situation.

The World Bank estimated in 2008 that a flu pandemic could cost $3 trillion and cause a 5 percent drop in world gross domestic product.

An outbreak of severe acute respiratory syndrome (SARS), which disrupted travel, trade and workplaces in 2003, killed 775 people and cost the Asia Pacific region an estimated $40 billion.

Antiviral medicine is effective against the swine flu bug if used early enough but no one is naturally immune.

Britain, France, Germany and the United States have issued travel alerts for Mexico, which relies on tourism as its No. 3 source of foreign currency. Japan has advised its citizens in Mexico to consider returning home soon.

(Reporting by Reuters correspondents worldwide; Writing by Malcolm Davidson; Editing by Keiron Henderson)

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