* FTSEurofirst drops 2.5 percent
* Dexia down 23 percent
* Goldman forecasts 10 pct fall in earnings in 2012
By Brian Gorman
LONDON, Oct 4 (Reuters) - European shares fell heavily on Tuesday morning, extending losses into a third session, with banks lower on escalating worries a Greek default will spark a banking crisis in Europe and Dexia plummeting to an all-time low.
The STOXX Europe 600 Banking Index fell 4 percent, and has lost more than 36 percent in 2011.
Franco-Belgian group Dexia , which plunged 23 percent, has come under increasing market pressure over its exposure to Greece. A board meeting went on into the early hours of Tuesday in an effort to resolve its problems.
Other banks to fall included BNP Paribas and
Deutsche Bank
The FTSEurofirst 300 index of top European shares was down 2.5 percent at 889.48 points at 0813 GMT, after falling 1.2 percent on Monday.
"What you are now beginning to see is they (investors) are now picking out the banks. Dexia is the weakest," said Justin Urquhart Stewart, director at Seven Investment Management.
"Politicians have to stand behind these banks. Whether you call it state support, nationalisation, you have to keep the financial system working otherwise we will end up with another credit crisis."
Euro zone finance ministers are reviewing the size of the private sector's involvement in a second international bailout package for Greece, a move that could undermine the aid programme and hasten the threat of a Greek default.
Across Europe, Britain's FTSE 100 , France's CAC40 and Germany's DAX fell 2.6-3.1 percent.
The Euro STOXX 50 volatility index , the euro zone's main fear gauge, rose 7.4 percent. The higher the volatility index, based on sell and buy options on the Euro STOXX 50 index, the lower the risk appetite.
The pan-European index is down more than 20 percent in 2011. However, Urquhart Stewart felt the drop has been overdone.
"Markets are being driven by irrational political sentiment. Look at the constituents of the markets: good cash flow, good profits, low levels of debt."
Goldman Sachs said average earnings forecasts for European companies will fall 10 percent in 2012. Goldman's downgrade came after it revised down its global economic growth forecasts to 3.5 percent for 2012 from a previous estimate of 4.2 percent.
"The uncertainty around these forecasts is substantial, largely hinging on the progress of credible solutions to the euro zone's funding problems," Goldman strategists say in a note. "We continue to prefer stocks with BRIC's exposure and those with high yield and growth."
But Goldman raised its target for STOXX Europe 600 for the next three, six and 12 months to 220, 240 and 265, respectively. Its previous targets were 210, 225 and 260.
The STOXX Europe 600 closed on Monday at 223.62 points.
Among other individual shares, International Airlines Group fell 4.7 percent on growing worries its transatlantic partner American Airlines is headed for bankruptcy. Shares of American Airlines parent AMR Corp closed 33 percent down on Monday on concerns the third-largest U.S. airline could file for Chapter 11 due, in part, to spiralling labour costs. (Editing by Dan Lalor)
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