European shares retreated on Friday afternoon after Spain signalled a higher deficit this year than previously agreed with the European Union, ending a rally that followed the ECB's funding exercise this week.

The FTSEurofirst 300 index of top European shares was down 0.2 percent at 1,084.38 points at 1305 GMT, retreating from 1,090.12, its highest level since Feb. 21.

Prices fell after Prime Minister Mariano Rajoy said Spain will base its 2012 budget on a deficit target of 5.8 percent of gross domestic product.

This is clearly less ambitious than the market was expecting, a German trader said, adding that the official EU-agreed objective was 4.4 percent.

It seems investors are just waiting for excuses for a correction, another German trader said.

Rajoy made his remarks on the sidelines of the two-day European summit that ends on Friday, where leaders have been arguing over the right balance between budget austerity and recapturing lost growth.

Finance ministers gave provisional approval to a second bailout for Greece, while leaders of 25 of the 27 countries are expected to sign a German-driven fiscal compact treaty to enforce EU deficit-cutting and debt reduction rules more strictly.

BANKS STILL CHEAP

Banking shares shed most of its early gains, leaving the STOXX Europe 600 Banking index up just 0.4 percent. The index has gained about 25 percent since mid-December when the ECB launched its first long-term refinancing operation (LTRO).

Analysts said that with so much liquidity in the financial system, the fear of an outright credit crunch had eased and expectations had grown grew that a recession in some European countries would be limited in depths and duration.

Still, banking shares remain cheap despite their recovery.

Since the ECB's first LTRO, Societe Generale has risen 50 percent, BNP Paribas has gained 27 percent, Commerzbank has added 50 percent and KBC is up 78 percent.

However, SocGen trades at 6.6 times 2012 expected earnings, Commerzbank at 7.2 times, BNP Paribas at 6.8 times, KBC at 4.8 times, well below a 10-year average price-to-earnings ratio of 10 for the sector, according to Thomson Reuters Datastream.

Barclays was up 3.1 percent after it said it tapped the ECB for 8.2 billion euros.

ING shares added 2.3 percent after a court victory which means it may sell fewer assets than expected.

Belgacom, down 4.2 percent, was the steepest faller on the STOXX 600 Index after Belgium's dominant telecom operator said its profit decline would accelerate in 2012.