* Europe to set up sovereign crisis mechanism
* Markets worry over haircuts on senior bank debt
* Senior bank debt no longer seen as risk-free
* Funding costs for banks to rise
By Douwe Miedema and Alex Chambers
LONDON, Dec 2 (Reuters) - Hints from European politicians that there could be greater risk in lending to banks in the future will raise the cost of funding for those deemed trustworthy and shut out the weak completely.
The 85 billion euro ($111.3 billion) bail-out of Ireland and its banks seemed to confirm a widely held market belief before the crisis: no country will ever allow a bank to go bust, making senior bank debt almost as safe as government bonds.
But European Union plans for new rules, in 2013, on how to deal with sovereign crises have done away with the notion that banks are always tacitly backed by governments, and may lead to a permanent rise in their cost of capital.
"It will be a very uncomfortable process. If you bought bank bonds five years ago, thinking it was pretty certain (you'd) be made whole by a government, that's maybe now changed," said Mike Harrison, an analyst at Barclays Capital.
"Bank debt could be becoming more (like) non-financial corporate debt, and so you price that accordingly."
In the years leading up to the crisis, investors charged banks as little as 0.3 percentage points more than governments pay, Barclays Capital data shows. At the height of the crisis, the difference had soared to 5.3 percentage points.
The spreads have roughly halved from that peak, but the new risks mean they are unlikely to return to their pre-crisis levels anytime soon, if ever at all.
Investors will charge the weakest banks more for borrowing, just at a time that regulators are telling them to hold more capital for every dollar they lend, and to shed some of their most lucrative but also riskiest businesses.
Next year will see heavy refinancing requirements from most banks, with a total of $340 billion in senior debt and 74.4 billion of government-backed bonds maturing throughout the year, according to data from JP Morgan.
BAIL-OUT, BAIL-IN
Fears that Brussels would force holders of senior bank debt to share the burden of Ireland's bail-out had rocked markets in the days leading up to the rescue package, designed to stem a crisis rooting in the country's banking system.
They recovered slightly when Finance Minister Brian Lenihan said the package was granted only on the explicit condition that taxpayers were to foot the entire bill, leaving investors in senior bank notes off the hook.
Forcing losses on the debt -- considered the safest because investors get paid out first in case of a default -- would have caused a market rout similar to the one after the collapse of Lehman Brothers, people in the market said.
But the threat remains.
Europe's so-called European Stability Mechanism to deal with future crisis, planned to come into force in mid-2013, will include "private sector involvement", the exact form of which will be decided on a case-by-case basis.
The package is designed for governments in trouble, not banks. But markets no longer clearly distinguish between the two, given the large government involvement in the banking sector in Europe since the start of the crisis.
"The crisis resolution package clearly points to increased likelihood of both sovereign (and) senior bank debt bail-ins and haircuts in future," brokerage Execution Noble said in a note. "We remain Underweight the European banks."
Depressed prices on subordinated debt, which regulators have insisted must take a hit when banks are bailed out, shows the market is fearful of additional bank failures.
Perpetual hybrid Tier 1 from Portugal's BCP and BES for instance, are trading at a whopping 1,300 and 1,200 bps over the risk-free rate respectively.
This year's stress tests proved most European banks had adequate capital, but the real problem is funding. With investors remaining reluctant to lend, the European Central Bank remains a crucial life support.
Investors are already gearing up for more change.
"No-one likes retroactive changes to the rules but they do happen and we get used to it, said Nigel Sillis, director of fixed income and currency research at Baring Asset Management.
"The most concerned parties are buy-and-hold investors with a lot in their bank book, like insurance companies. For the hot-money investors and more tactical asset manager, it's something we'll get over in a quarter or two." ($1=.7639 Euro) (Additional reporting by Matthew Atwood at IFR; Editing by Jon Loades-Carter)