Germany's Hypo tests European bank stability vow

By Gernot Heller and Keith Weir

BERLIN/LONDON (Reuters) - Germany said on Sunday that it would not allow troubled lender Hypo Real Estate to infect its banking system in the first test of a pledge by European leaders to restore financial stability.

Officials from the German government, central bank and financial regulator struggled to save Munich-based HRE after banks and insurers pulled out of a state-led 35 billion euro ($48.5 billion) rescue plan after financing problems emerged.

"The German government says today that it will not allow the problems of one financial institution to become a problem for the entire financial system," Chancellor Angela Merkel told a news conference.

The German government also said on Sunday it would guarantee private deposit accounts as part of its reaction to the banking crisis. "The state guarantees private deposits in Germany," finance ministry spokesman Torsten Albig said. A second ministry spokesman said the guarantee was unlimited.

European banks have been hit hard by the fall-out from a crisis which began in the United States when the housing market collapsed and bad mortgage debts multiplied.

The escalating crisis has paralysed wholesale money markets, caused huge volatility on stock markets and changed the banking landscape in a matter of weeks.

HRE is relatively small when compared to other firms in Frankfurt's blue-chip DAX index of leading companies, but its role as a lender for commercial property, infrastructure and government financing makes it a major financial player.

It accounts for about a fifth of Germany's 900 billion euro Pfandbrief -- or covered bond -- market, which is a crucial source of refinancing for the financial sector.