* Lloyds, RBS, KBC may face tougher-than-expected sanctions
* Investor appetite for rights issues could wane
* European bank shares build on losses
(Recasts, adding investor comment, details, updates stocks)
By Kirstin Ridley and Steve Slater
LONDON, Oct 27 (Reuters) - Investors are shunning European bank shares after an EU-imposed break-up and retrenchment of Dutch ING Groep sparked fears Belgium's KBC and UK peers face tougher-than-expected sanctions in return for state aid.
The shake up at the flagship Dutch bancassurer had set a tough precedent for other bailed-out banks, especially Lloyds Banking Group, Royal Bank of Scotland and KBC, analysts said.
"Forced divestments, larger balance sheet reductions and restrictions on pricing are all more penal than we had expected and could potentially have a negative readacross for some other European banks," said Andrew Stimpson, analyst at Keefe, Bruyette & Woods.
Fund managers said ING's surprise 7.5 billion euro ($11.2 billion) cash call, on top of the sale of a 1.4 billion pound stake in Britain's Barclays last week, would do little to help Lloyds raise 11 billion pounds-plus ($18 billion) and RBS raise a possible 3-4 billion pounds in expected rights issue.
"ING's rights issue was a surprise for the market and maybe it has mopped up a little bit of the appetite that might have been there for more banking paper," said a senior investment manager at a large investment fund.
"This is most definitely going to make life more difficult for Lloyds and even RBS when they come out with their rights issue -- ING and Barclays (investor QIA) have beaten them to the punch."
Most bank shares pared sharp morning losses by mid afternoon, but RBS was still 4.2 percent lower and Lloyds was down 2.3 percent, underperforming a 0.9 percent weaker DJS Banks index. KBC rebounded to trade flat.
PERTURBING PRECEDENT
Market eyes have long been trained on the plans for ING by European Competition Commissioner Neelie Kroes, who is keen to leave her mark on the industry before she bows out around year-end.
Analysts said there was talk of gagging orders imposed on all sides after tense discussions between ING and Kroes, and the outcome was a useful guide to the restructuring and asset sales she could force on state-rescued UK banks.
"ING would not have been broken up had it not been for pressure from Brussels," a senior EU official said, warning that it was a sign of things to come.
But Kroes's so-called "remedies" for state aid received by banks brought to their knees by the credit crises went far further than analysts had expected, sending ING's shares plunging and wiping 25 percent off the company's market value in two days, at one point.
The measures will cut ING's balance sheet by 30 percent. It will dispose of its insurance and asset management operations, split off some Dutch mortgage operations and sell ING Direct USA, its prized American online banking business.
RBS and Lloyds were already expected to have to sell hundreds of branches, as well as other assets, and shrink their balance sheets. KBC and Franco-Belgian Dexia are also awaiting rulings from the Commission. ($1=.6718 Euro) ($1=.6091 Pound) (Additional reporting by Raji Menon in London and John O'Donnell in Brussels; editing by Simon Jessop)