* FTSEurofirst 300 down 0.7 pct in early trade
* Banks lead broad-based fall
* Debt crisis remains key focus
By Simon Jessop
LONDON, July 18 (Reuters) - European shares extended the previous week's declines on Monday as bank stocks took a fresh beating on the first trading day following a much-hyped capital stress test that failed to dispel fears about the impact of the regional debt crisis.
The failure of eight smaller banks was in line with market expectations but the test was not considered strict enough by many in the market and also failed to factor in the potential for a Greek sovereign default.
Added to the failing banks, a further 16 were close to failing the test -- by seeing their core capital slide below 5 percent in the face of a prolonged recession -- and all of them may need to take action to shore up their balance sheets.
In response, the STOXX Europe 600 index was down 1.5 percent by 0808 GMT, led by Banco Popolare , UniCredit and Intesa SanPaolo , all down between 3.5 percent and 4.8 percent.
Only a handful of banks managed to withstand the weight of
early selling pressure, buoyed by a strong showing in the test
in the case of Danske Bank , up 1.3 percent, and
short-covering on the part of several Greek lenders, including
National Bank of Greece
The scale of the falls in the heavyweight banking sector led a broad-based retreat from risk and by 0811 GMT, the FTSEurofirst 300 index of leading blue-chips was down 0.8 percent at 1,078.38 points.
The falls leave the index on track to record its sixth day of trading losses out of the last seven, and with a year-to-date loss of 3.9 percent.
Banking analysts at Espirito Santo described the stress test as "a missed opportunity to address sector - and indeed sovereign - concerns" as it failed to include 4.8 trillion euros of wholesale/interbank maturities.
The omission was "crucial... given the structural over-reliance on wholesale funding and prospect for real economic feedback from the sovereign 'crisis'," they said in a note.
Based on the stress test results, large-cap European banks would need 23 billion euros of fresh capital in the event Greece, Ireland and Portugal default and "suffer real economic negative feedback loops".
"Adding Spain and Italy into the analysis suggests a capital need of 61 billion euros," they added.
Failure to address the potential for a Greek default, as well as persistent fears that contagion -- in the form of unsustainable bond yields -- could spread to Italy was set to underpin investor sentiment.
"The market is going to keep an eye on sovereign debt, and especially the spreads," Frank Vranken, chief strategist at BNP Paribas Private Banking, said.
"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.
Equinet analyst Philipp Haessler agreed, describing the debt issue as "the key risk factor", and citing Deutsche Bank, Santander and Intesa SanPaolo as his top picks.
Early on Monday, Italian 10-year bond yields were around 5.86 percent, just below the 6 percent level that contributed to a selloff in Italian stocks last week.
RISK-OFF
While banks took up most of the top spots on the regional stock fallers' list, quarterly earnings added to the gloom.
Electronics giant Philips , down 0.3 percent in heavy trade, with volumes around half the 30-day daily average after just an hour of trade, reported a surprise second-quarter net loss of 1.2 billion euros on costs tied to recent acquisitions.
In spite of the recent stock price falls and in the face of other macroeconomic headwinds, including weakening economic data and political wrangling over the U.S. debt ceiling, analysts at UBS said they remained "neutral" on equities.
"After a bounce, markets remain rangy and directionless. Concerns about sovereign risk and the 'soft patch' act as restraints on risk-taking, while good corporate earnings and undemanding equity valuations offer resistance to deeper sell-offs," they said in a note. ($1 = 0.708 Euros) (Additional reporting by Josie Cox in Frankfurt; Editing by Jon Loades-Carter)
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