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EU targets state-owned Russia banks in sanctions draft

* Proposal to ban buying new debt, shares in state-owned banks

* Diplomat says EU action would deepen Russian market uncertainty

* Merkel wants rapid progress on tougher sanctions

* EU patience with Russia running out

BRUSSELS, July 24 (Reuters) - The European Union would target state-owned Russian banks and their ability to finance Moscow's faltering economy in its most serious sanctions so far over the Ukraine crisis under proposals considered by EU governments on Thursday, diplomats said.

Ambassadors of the 28-nation bloc met in Brussels to discuss options drafted by the executive European Commission in response to the downing of a Malaysian airliner in an area of eastern Ukraine held by Russian-backed separatists.

In the key measure, European investors would be banned from buying new debt or shares of banks owned 50 percent or more by the state. These banks raised almost half of their 15.8 billion euro ($21.29 billion) capital needs in EU markets last year.

"If implemented such sanctions would be a serious blow to the Russian economy, exacerbating an already very likely recession this year and sustaining an economic depression for longer," said analyst Michal Dybula of BNP Paribas.

The proposals also included an arms embargo, although diplomats said it would apply to future deals and would not bar delivery of a French helicopter carrier built for Russia under a 2011 contract.

The EU is also considering restricting exports of technology for deep-sea drilling, shale gas and Arctic energy exploration under one of the options, diplomats said.

After months of hesitation, powerful EU states including Germany, Moscow's biggest trade partner, are now pushing for quick action as they believe Russia has consistently failed to meet international demands to end violence in Ukraine.

The crash of Malaysian Airlines flight MH17 last Thursday, which U.S. intelligence officials believe was shot down in error by the rebels with a Russian-supplied missile, has stiffened Europe's resolve, officials said.

The proposals to restrict access to EU capital markets and defense and energy technology would mark the first time the Europeans have gone beyond asset freezes and visa bans to target sensitive sectors of the Russian economy.

The Commission did not propose a ban on buying Russian government bonds, a diplomat said. However, the cost of insuring Russian sovereign debt against default rose on the news.

The largest banks with state ownership of over 50 pct are Sberbank, VTB, Russian Agriculture Bank (Rosselkhozbank) and VEB.

"Restricting access to capital markets for Russian state-owned financial institutions would increase their cost of raising funds and constrain their ability to finance the Russian economy," an EU diplomat said on condition of anonymity.

"It would also foster a climate of market uncertainty that is likely to affect the business environment in Russia and accelerate capital outflows," the diplomat said.

MERKEL WANTS ACTION

A spokesman for German Chancellor Angela Merkel said on Wednesday she wanted to see rapid progress at the EU meeting.

"The chancellor believes quick decisions are needed," said deputy spokesman Georg Streiter, adding that EU leaders had expressed their readiness last week to hold a special summit if necessary to approve the measures.

Berlin believes the EU could move to impose sanctions on sectors of the Russian economy by the end of July unless Moscow acts quickly to defuse the crisis in eastern Ukraine, an EU source said.

German officials told a closed-door Brussels briefing for industry representatives that Berlin favors a time limit on the duration of new sanctions to provide an opportunity for relations to return to normal, the source said.

The government regretted that things had come so far but "but after so much time without relevant cooperation by Russia there was now within the EU as well as the German government a high degree of determination. It was now up to Russia to avert the next step," the source said.

Despite German urgency, several diplomats said they believed economic sanctions would not be finally agreed on Thursday and a further ambassadorial meeting next week may be required.

Ambassadors were expected to agree on Thursday to add the names of some Russian companies accused of helping to undermine Ukraine's sovereignty to the bloc's sanctions list, using new expanded criteria.

EU foreign ministers have said that to avoid tougher sanctions, Moscow must stop the flow of weapons across the border to Ukraine and use its influence with pro-Russian rebels in Ukraine to allow an independent investigation into the downing of flight MH17 with the loss of 298 people.

Despite threatening tough action since Russia's annexation of Ukraine's Crimea region in March, the EU has been divided over imposing economic sanctions on its main gas supplier.

Britain and France have clashed openly over Paris's plan to deliver Mistral helicopter carriers to Moscow.

British Prime Minister David Cameron said on Monday Paris's plan to press ahead with the 1.2 billion-euro ($1.7 billion) order after the downing of the Malaysian Airlines plane would be "unthinkable" in Britain.

French Foreign Minister Laurent Fabius hit back, telling Cameron he should do something about UK-based Russian oligarchs close to Putin.

Trade data indicate that Germany and Italy have most to lose if the EU makes good on its sanctions threat against Russia, while Britain's overseas territories are soaking up the lion's share of capital streaming out of Russia.

If ambassadors agree to the sanctions, it remains uncertain whether EU leaders would hold an extraordinary summit to approve them or whether governments could approve the decision in writing without a meeting.

It may take until next week to publish a first list of people and companies targeted with asset freezes under the wider measure. Ambassadors were also working on additional measures to restrict EU trade with and investment in Crimea.

($1 = 0.7423 Euros)

(Additional reporting by Adrian Croft, Jan Strupczewski, Tom Koerkemeier, Martin Santa and Robert-Jan Bartunek in Brussels, Stephen Brown in Berlin and Katya Golubkova in Moscow; Writing by Adrian Croft; Editing by Paul Taylor)