By Marius Zaharia and Sudip Kar-Gupta
LONDON, Feb 5 (Reuters) - Greek financial markets came under heavy selling pressure on Thursday after the European Central Bank raised the stakes for the new government in Athens to strike a new aid-for-reform deal with its European partners.
The ECB said it would stop accepting Greek bonds in return for funding from Feb. 11, shifting the burden onto the Greek central bank and isolating Athens at least temporarily until a deal is reached.
In a foretaste of the probable consequences of a prolonged deadlock between Athens and other EU capitals, Greece's banking stocks index plunged some 14 percent, driving the broader ATG equity index down by about 6 percent.
"As severe as the ECB announcement appears, it likely represents the central bank's opening gambit in what will be several rounds of negotiations with Athens and Berlin over the next four months," said City Index chief global strategist Ashraf Laidi.
Greek stocks were still above the lows hit in the aftermath of the left-wing Syriza's election victory less than two weeks ago, as investors perceived its leaders to have shown some openness to compromise as they tour Europe in search of allies.
Greek 10-year bond yields rose by almost a full point to 10.87 percent, while three-year yields rose by more than two percentage points to 18.79 percent.
"I can't help thinking that the party that is going to have to make the most compromises to get a deal done is the Greek government, as I just do not see Mrs Merkel doing anything other than playing hardball," said Gary Jenkins, chief credit strategist at LNG Capital.
"However, I didn't expect the trigger to be pulled by the ECB so quickly."
The Greek central bank will have to provide its banks with tens of billions of euros of additional Emergency Liquidity Assistance (ELA) in coming weeks, a step it takes at its own risk, ringfencing those banks' funding problems from the rest of the euro zone.
Alpha Bank shares were down by 9 percent and Eurobank shares plunged 13.3 percent. Shares in National Bank of Greece fell 14.6 percent.
The decision is a blow for Greek Finance Minister Yanis Varoufakis, who was due to meet his German counterpart Wolfgang Schaeuble later on Thursday. A document prepared by Germany for a meeting of EU finance officials made clear Berlin wants Athens to go back on promises to raise the minimum wage, halt unpopular sales of national assets, rehire fired public sector workers and reinstate a Christmas bonus for poor pensioners.
The cost to insure Greek government debt against default via five-year credit default swaps rose 3 points to 43 points upfront, the highest since the 2012 debt restructuring, according to data from Markit.
Borrowing rates in the euro zone's weaker countries rose only moderately, suggesting investors were not worried that the ECB's tough stance would prevent an eventual deal between Greece and its EU partners.
Italian and Spanish 10-year government bond yields rose 4-5 basis points each to 1.59 percent and 1.48 percent.
"I think the contagion effect should remain very limited. This is not yet the end of the world for Greek banks," said Patrick Jacq, rate strategist at BNP Paribas.
He said, however, that the liquidity situation for Greek banks might become "dangerous" if deposit outflows pick up.
The FTSEurofirst 300 index of top European shares was down 0.4 percent at 1,481.86 points. Italy's MIB index dropped 1.3 percent and Spain's IBEX was down 1.1 percent.
Ten-year German Bund yields fell 3 basis points to 0.34 percent as investors sought top-rated assets.
"The risks attendant to failing to reach a compromise of some form are too high for both sides for a negative outcome to be the more likely scenario," Rabobank strategists said in a note. (Graphics by Vincent Flasseur; Editing by Dominic Evans and Kevin Liffey)