* FTSEurofirst 300 index falls 1.7 percent
* Banks drop on euro zone debt worries
* Focus on Thursday's euro zone meeting
By Joanne Frearson
LONDON, July 18 (Reuters) - European shares fell on Monday to a four-month closing low, led by banks on worries this week's euro zone meeting would fail to agree a second bailout package for Greece and concerns that the latest bank stress tests were unrealistic.
The STOXX Europe 600 Banks index fell 3.2 percent and has lost 27.7 percent since mid-February, when worries intensified about the global recovery and the euro zone debt crisis.
French and German banks, which have heavy exposure to Greek debt, were among the major fallers in the sector, with Societe Generale , BNP Paribas and Commerzbank down 3.6 percent to 5.5 percent.
There was still a divide over the role of private sector involvement in a second Greek bailout and fears were growing a rescue could fail, triggering a possible default.
"On Thursday, investors want to know what form private sector involvement would take and how the European Central Bank will help", said Veronika Pechlaner, a manager of the 100 million euro Ashburton European equity fund. "The market does not want any more postponement and is taking off risk."
Analysts were also wary the bank stress tests did not take into account what would happen if Greece defaulted and only gave a scenario of banks' ability to withstand a long recession.
The European Bank Authority was assuming a 15 percent loss on Greek bonds and a 1 to 2 percent "haircut" on Irish and Portuguese debt, but a much more severe loss is implied by current market prices.
"In the stress tests, the capital raising is so small and is not enough at this point. The results have really disappointed," Pechlaner said.
Eight smaller institutions failed the "stress tests", while a further 16 only passed by a small margin. They will all need to take action to shore up their balance sheets.
The pan-European FTSEurofirst 300 index of top shares closed down 1.7 percent at 1,067.96 points and was holding just above a support level of 1,066 - its low of March and a level from which it has previously bounced.
The index is down 3.9 percent so far this month, on track to post its biggest monthly percentage drop since May 2010.
France's CAC 40 has lost 8.3 percent this month, in line with the performance of euro zone peripheral markets. Spain's IBEX 35 is down 9.8 percent, Italy's FTSE MIB is 11.4 percent lower and Portugal's PSI 20 is off 10.4 percent.
By comparison, Germany's DAX is down 3.6 percent and Britain's FTSE 100 is off 3.2 percent.
The Euro STOXX 50 volatility index , Europe's main fear gauge, rose 10.3 percent, its highest close since March.
The higher the volatility index, the lower investor appetite for risk.
EURO ZONE WORRIES
Adding to worries about the euro zone debt crisis, Italian and Spanish bond yields headed towards 7 percent -- a level beyond which funding costs are perceived to be unsustainable.
"The market is going to keep an eye on sovereign debt, and especially the spreads," said Frank Vranken, chief strategist at BNP Paribas Private Banking.
"As long as there is this eerie feeling that Italian 10-year yields can go above 6 percent; this is really what grips the market and grips the banking sector," he added.
Peripheral Italian banks were hit hard. Intesa Sanpaolo closed down 6.51 percent and UniCredit fell 6.4 percent. (Editing by David Cowell)
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