Asian shares fell Monday as uncertainty remained over how euro zone leaders would respond to mounting funding difficulties for European banks, and an apparent failure by U.S. politicians to agree on deficit reduction hurt sentiment.

The U.S. congressional deficit-reduction committee was set to formally announce that its three-month-long effort to bridge partisan differences over taxes and spending has failed, aides told Reuters.

Automatic spending cuts of $1.2 trillion over a decade are due to start in 2013, after elections in 2012, if the super committee of six Democrats and six Republicans cannot agree.

MSCI's broadest index of Asia Pacific shares outside Japan extended its losses to fall 1.5 percent on Monday after posting its biggest weekly loss in about two months last week. Japan's Nikkei stock average <.N225> fell 0.1 percent.

It is a minor negative, there is a few questions to be asked -- do Moody's and Fitch for example move to downgrade the U.S., said HSBC's head of global equity strategy, Garry Evans.

Market expectations for a deal were low, but a failure of the committee could remind investors of the risks posed by a dysfunctional U.S. government.

The committee was created after a battle over the federal government's debt ceiling nearly shut it down and led to a first-ever cut in the United States' AAA credit rating by Standard & Poor's in the summer, roiling financial markets.

While there is no immediate market pressure on the United States, focus will turn to the budget, and a failure to deliver effective measures could result in a fairly significant contraction in the United States next year, fuelling concerns about a growth slowdown as well, HSBC's Evans said.

CRUSHING VICTORY

Europe's messy politics appeared to be heading in the direction of carrying out vital fiscal reforms, offering some relief to investors.

In Spain, the center-right opposition People's Party won a crushing election victory and is expected to push through drastic austerity measures to try to prevent Spain being sucked deeper into the debt storm threatening the euro zone.

Those policies would undoubtedly be welcomed by markets, yet may not be enough to stabilize the Spanish sovereign, Barclays Capital analysts said in a research note. Ultimately, we think it is likely that the ECB will need to step up its support.

In Italy, Prime Minister Mario Monti won an overwhelming vote of confidence on Friday after warning politicians against sabotaging a sweeping package of fiscal reforms.

But political wrangling in Greece, which has teetered on the brink of default and set off the panic selling now widespread in bonds of other highly-indebted euro zone members, threatened the new prime minister's bid to win vital bailout funds from European leaders.

The euro drifted up to $1.3525 on Monday from $1.3519 late in New York on Friday, but was well below Friday's peak of $1.3614. The dollar index measured against six key currencies was down 0.1 percent.

PRESSURE ON ECB RISING

Italian and Spanish government bond yields eased on Friday, after the European Central Bank intervened in markets to alleviate pressure from investors demanding higher premiums for bonds issued by highly-indebted countries.

The ECB has resisted rising pressures to step up purchases of euro zone sovereign debt, or the idea of lending to the International Monetary Fund to bail out troubled euro zone economies, despite a growing market perception of the bank as the last hope to stop the debt crisis from spreading globally.

Reflecting worsening dollar funding strains for European banks, euro/dollar three-month cross-currency basis swaps widened further on Friday to -138.50 basis points, the most since the height of the Lehman crisis in 2008.

The difference between the three-month dollar offered interbank Libor rate and overnight index swaps hit 38 basis point, the largest since June 2009.

The probability is quite high that European woes will further shrink global capital markets, aggravating interbank funding strains and drying up investment flows, said Bob Takai, general manager of Sumitomo Corp's energy division.

Sentiment remained cautious in Asian credit markets, with spreads on the iTraxx Asia ex-Japan investment grade index widening around 3 basis points on Monday.

In a sign of risk-aversion, investors put fresh cash into U.S. equities, bonds and precious metals funds, along with a big allocation to inflation-protected bond funds to 80-week high of $512 million in the week ended November 16, data from EPFR Global showed on Friday.

(Editing by Alex Richardson)