* Spanish banking problems weigh heavily on euro
* Euro hits near 2-yr low vs dollar; dollar index at 20-mth high
* Focus on rising Spanish debt yields and risk of bailout
* Italy pays hefty price to sell bonds
By Jessica Mortimer
LONDON, May 30 (Reuters) - The euro fell to it lowest in 23 months against the dollar on Wednesday as concerns grew about Spain's ailing banking sector and soaring borrowing costs, and after Italy was forced to pay dearly to sell debt.
The euro was seen highly vulnerable to further falls, with many analysts looking for a drop towards $1.20.
Concerns are growing that Spain may have to tap debt markets at a time when bond yields are near unsustainable levels. Market players fretted that it may be forced to seek an international bailout.
Adding to the euro's woes, Italy sold bonds at a very high cost, with 10-year yields topping 6 percent for the first time this year as sentiment on the indebted economy looked vulnerable to contagion from Spain's worsening problems.
The euro fell around half a percent to $1.2433 on trading platform EBS, its lowest since early July 2010, as real money and institutional investors stepped up sales of the currency.
"The euro is in an extremely vulnerable position and downside risks are very strong indeed ... The Spanish banking crisis has the potential to knock the stuffing out of the euro zone irrespective of the Greek election results," said Jane Foley, senior currency strategist at Rabobank.
"The issues for Spain are undoubtedly huge and most people are coming round to the idea that it will need to go outside of its borders for assistance. The longer it delays the more the risk of a bank run."
More falls could see the euro test a reported options barrier at $1.2400. Below there it has little chart support until $1.2151, a low hit in late June 2010, and then the 2010 low of $1.1876.
The common currency also lost more than 1 percent against the safe-haven yen, taking it to a four-month low of 98.274 yen.
The latest drop in the euro comes as the 10-year Spanish government bond yield continued to inch towards 7 percent. That was the level when other peripheral euro zone countries had to seek an international bailout.
The cost of insuring against a Spanish default hit new highs and the Madrid stock market hit a nine-year low.
The euro had gained some reprieve earlier in the week after Greece's pro-bailout parties regained an opinion poll lead ahead of elections on June 17, easing market fears of a messy Greece exit from the euro zone.
But the single currency's bounce proved short-lived as the market's focus shifted to Spain. The euro's failure to breach resistance near $1.2625 left the euro looking vulnerable.
"Our short-term fair value model is showing the euro should be around $1.21 with the euro a sell against a broad range of currencies," said Melinda Burgess, currency strategist, at RBS Global Banking.
A government source told Reuters on Tuesday that Spain would likely recapitalise Bankia, which asked for 19 billion euros on Friday, by issuing new debt and possibly drawing cash from the bank restructuring fund and Treasury reserves.
The euro's losses benefited the safe-haven dollar and yen, helping the dollar index, which measures its value against a basket of currencies, rise to a 20-month high of 82.749.
Technical analysts said a monthly close about the 100-month average in the dollar index around 81.82 may herald a shift in the longer-term trend of the dollar and reverse a multi-year drift lower.
The dollar also rose to a 15-month high against the Swiss franc at 0.96593 francs.
The higher-yielding Australian dollar fell 0.8 percent to $0.9765, slipping towards a six-month low at $0.9690, after weaker-than-expected retail sales data underscored the case for interest rate cuts.