By Daniel Flynn and Jean-Baptiste Vey

(Reuters) - A French banking system shaken by a crisis of confidence and hobbled by the need to deleverage and write down assets could choke off credit to consumers and businesses and shatter France's fragile recovery.

France's economy was already stuttering, with zero growth in the second quarter, before alarm over its banks' exposure to Greece and their reliance on short-term wholesale funding battered banking sector share prices and jolted global markets.

Buffeted by a Moody's downgrade of Societe General <SOGN.PA> and Credit Agricole <CAGR.PA>, and the increasing unwillingness of U.S. money market funds to lend dollars to fund their short-term operations, France's banking sector now seems set for a period of retrenchment.

While an agreement among central banks last week to offer three-month U.S. dollar loans to commercial banks staved off fears of Europe's money markets freezing, as they did during the 2008 credit crunch, Bank of France Governor Christian Noyer warned that French banks would have to shrink their balance sheets to adjust to tougher funding conditions.

"You have the perfect cocktail for a lasting recession," said Alexandre Law of consultants Xerfi, which advises French businesses. "It's quite clear that banks are going to halt their riskiest lending, if they haven't done so already."

Finance Minister Francois Baroin told France's Europe 1 radio on Sunday that banks must not tighten the taps on credit. "The strengthening of banks' balance sheets through gradual increases in their capital must not take place at the expense of access to credit by companies or individuals. The banks know that," he said.

Figures for July, the last available month, showed an annual slowdown in new mortgages and consumer loans, even before doubts about the banks intensified.

Consumer sentiment is likely to have worsened since then. A survey by pollsters IFOP poll published on Web site Atlantico on Friday showed that some 44 percent of those questioned are not confident in the solidity of their banks.

With consumption -- which accounts for two thirds of economic activity in France -- shrinking in the second quarter, economists had pinned their hope for growth this year on a rebound in investment by businesses, which have been strengthening their balance sheets after the crisis.

Bank of France figures showed that new bank lending to non-financial businesses had been steadily growing since the credit crisis, rising 4.5 percent year-on-year in July. But business leaders say the mood has soured dramatically in recent weeks.

"People are worried," said Jean-Eudes du Mesnil du Buisson, secretary-general of the CGPME confederation of small- and medium-sized businesses, after meeting members on Wednesday.

"A lot of them said they were considering whether to put off certain investments and, in some cases, delay hiring," he said. "If the doubts are not lifted by the end of the month, we will see direct consequences on economic activity."

FRANCE'S GREAT DELEVERAGING?

President Nicolas Sarkozy's government cut its growth forecast for this year to 1.75 percent from 2.25 percent last month and unveiled a slew of measures to ensure it hits deficit-cutting targets deemed key for France to keep its AAA credit rating. Even before this month's banking turmoil, most economists said growth was likely to come in below 1.4 percent this year.

France's economy relies on bank loans for two-thirds of its financing, a far higher figure higher than in market-based systems like the United States, leaving it particularly exposed to the health of its banking sector.

Its lenders were until recently the envy of their European peers as they weathered the financial crisis without massive losses or nationalisations. But while Britain and Switzerland demanded their big banks beef up capital buffers quickly after the crisis, France opted for its traditional close surveillance of bank lending, which served it well during the crisis.

As a result, French banks' Tier 1 capital ratios, a measure of their ability to absorb losses, stand between 10.6 and 11.4 percent, below the 11.6 to 17.8 percent range at top banks in Britain, Germany and Switzerland, according to Thomson Reuters Starmine.

That, analysts say, left French banks exposed to anxiety over their levels of euro zone sovereign debt holdings and reliance on short-term funding, culminating in the Moody's downgrade of Societe General and Credit Agricole on Wednesday.

Bank of France Governor Noyer has called for banks to speed up the reinforcement of their capital ratios under new Basel III rules by cutting dividends and retaining more of their profits.

Officials suggest that French banks may also need to take more severe write-downs on their holdings of Greek debt to remove doubts over their balance sheets. Noyer has called for the European Banking Authority to set guidelines here.

Meanwhile, BNP Paribas <BNPP.PA> and SocGen have signaled plans for asset sales expected to total more than 100 billion euros to cut their reliance on wholesale funding. Question marks remain over how quickly they can do this and at what price.

BNP Chairman Michel Pebereau insisted on Thursday there was no threat to lending to consumers and small-businesses in the bank's core European markets of France, Belgium and Italy: "We're doing what is needed."

Figures suggest that European banks are becoming wary of lending. Overnight deposits at the ECB spiked to 198 billion euros on Tuesday, versus less than 10 billion at end-June, despite an ECB pledge to furnish unlimited short-term liquidity.

"Everything is in place for a massive contraction of credit," Pierre Mariani, CEO of Franco-Belgian financial services group Dexia <DEXI.BR>, warned this week.

CRISIS OF CONFIDENCE

"This enormous financial nervousnesss involves a lack of visibility about the coming months: we are in a patch of fog."

A survey of companies' cash positions by the REXECODE think-tank and the AFTE association of business treasurers found a sharp deterioration in the last two months, leaving them close to the level of April 2008, a month before France hit recession.

Company treasurers reported a rise in the difficulty of securing bank loans and an increase in their cost, while more clients delayed payments, worsening companies' cash position.

One Paris-based banking source said he was concerned that the race to reduce balance sheets would hurt French banks market share and handicap French companies doing business overseas.

"Financing Airbus, that is in dollars. If French banks won't do it, will it be JP Morgan <JPM.N>? Or will it be no-one?"

French officials have resisted calls for major French banks to raise their capital levels above the threshold required by the new Basel III rules, fearing that this would limit their financing of the economy.

Noyer has insisted that French banks do not need outside capital, particularly not from the government. Officials argue that Europe's debt crisis must be tackled at source: by deficit-cutting measures in troubled peripheral countries.

But, in a potentially worrying sign for banks' deposit base, a survey by pollsters CSA published in Les Echos on Thursday showed two thirds of consumers were concerned that the banking crisis could affect the solidity of their savings.

"We are in a crisis of confidence and it is very hard to get out of a crisis of confidence," said Mesnil du Buisson of the CGPME confederation. "People are going to be even more cautious this time round because they have at the back of their minds the brutality of the shock of 2008."

(Additional reporting by Lionel Laurent; editing by Janet McBride)