* Short-term funding trouble may return to dog Spanish banks
* Investors fret over source of bank recapitalisation cash
* Banks still shut out of funding market, repo cost may rise
LONDON, May 10 (Reuters) - Spanish banks could face fresh funding problems if plans to recapitalise the financial sector fail to convince investors it can withstand continued heavy losses on property loans.
Spain effectively nationalised Bankia, its fourth-biggest lender, on Wednesday in an effort to stall a four-year-old banking crisis, and is expected to outline further measures to shore up the system on Friday.
Financial sources told Reuters that Spain plans to force banks to set aside an extra 35 billion euros against loans made to the building sector, in addition to the 54 billion euros already set aside for this year.
But, with most Spanish banks unable to raise fresh capital from spooked investors, the prospect of further cash from already strained public coffers has done little to assuage concerns and access to vital funding markets has seized up.
The European Central Bank countered a previous funding freeze by offering three-year loans to banks. Analysts say Spanish banks borrowed enough to cover redemptions for 2012.
But that relief is already waning and the latest crisis of confidence over long-term solvency is threatening banks' ability to resume normal funding when the ECB-bought calm runs out, and to cut off access to cash through the widely-used repo market.
"The problem is that liquidity doesn't fix solvency. This is a capital issue," said Alberto Gallo, head of European macro credit research at RBS.
"You can make the patient survive with life support and anesthesia but eventually you need to do surgery which includes recapitalisations, and potentially cutting out some of the bad parts of the system which are insolvent."
FUNDING FREEZE
Spanish banks were able to dip a toe in the funding markets earlier this year with a flurry of debt issues, but that window seems to have slammed shut.
"(The market) is closed to them completely... the funding costs are just too high and they just wouldn't get a deal away; that's the bottom line," said Suki Mann, credit strategist at Societe Generale in London.
The ECB has shown no willingness to offer banks more cash, meaning they will eventually need to return to investors.
It may take more to unlock market access than forcing banks to acknowledge potential losses and injecting fresh capital, with investors doubtful about where that money will come from.
Spain's shaky public finances have triggered a selloff in its bonds. This in turn hits the domestic banks that hold much of the debt. If recapitalising banks further strains the budget the positive effect of the new capital could be quickly diluted.
SOVEREIGN-BANK FEEDBACK
Rating agencies have expressed concern over the burden banks put on Spain's creditworthiness, and cuts to individual banks' ratings may stir up more problems.
Spanish banks still use repurchase (repo) markets, using government bonds to raise short-term cash, but further rating downgrades could threaten that important sources of finance.
Most Spanish banks use clearing houses to reduce the risk and cost of repo trades. Current rates are around 30 basis points but the cost could rise sharply if credit ratings slip.
ICAP estimates a downgrade to BBB- would double the 'initial margin' amount clearers require to offset risks, while a cut to BB+ would triple that cost.
This would probably increase dependence on the ECB, add to uncertainty in the market and reinforce the sovereign-bank feedback loop that is threatening Spain's fiscal stability.
"(Banks) need to have access to market funding, both in long-term and short-term markets. It would be an enormous strain on the ECB and investors would be hugely unnerved by the fact that a bank cannot access funds from the market,"
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