The top share index retreated on Thursday, with nervous investors ditching riskier assets such as banks and retailers, as corporates showed signs of stress in the face of the intensifying debt contagion in Europe.

London's blue chip index <.FTSE> shed 85.88 points, or 1.6 percent to 5,423.14, with the FTSE volatility index <.VFTSE>, up 10.2 percent showing investors were more pessimistic about the economic outlook.

Banks fell 2.3 percent as funding stress grew in the sector, with the euro zone sovereign debt crisis seeping deeper into countries such as France and markets looking to the European Central Bank to take more dramatic action.

Banks were under pressure from the start of the day after Ratings agency Fitch voiced concern over U.S. banks' European exposure.

That pressure intensified as Spain's bond yields rose to unsustainable levels long-term following a bond auction.

French bond yields rose too after its own bond auction, while Italian yields remained dangerously high on fears Europe's debt crisis could spell the end of the euro.

If the gathering collapse in European bond markets is not arrested, then the economic damage will be greater than equities are discounting, said Andrew Bell, chief executive of the 1.1 billion pounds Witan Investment Trust.

COMMODITIES WEAK

Miners and integrated oils fell too, in tandem with weakening commodity prices as the uncertainty surrounding Europe's debt crisis threatened demand in the sector.

BHP Billiton , the world's biggest miner, fell 2.8 percent as it turned more wary on the outlook for commodity markets in the face of tighter access to credit, but said conditions are not as bad as during the global financial crisis.

Traders said technical factors pointed to potential further downside for the UK FTSE 350 Mining sector, with a move back to the mid-October lows around 18,700 possible, a correction of some 8 percent from the current levels of 20,360.

Commodities group Glencore , however, bucked the weak trend, rising 1.9 percent as the firm said third-quarter activity in its closely watched marketing arm was solid despite slowing global growth.

Fred Moore, manager of the Newton European Higher Income Fund, said despite the gloomy macro outlook there were still pockets of value for investors to boost there returns.

The Euro zone crisis remains unresolved but we maintain that this creates even more investment opportunities as stocks were sold indiscriminately over the summer.

He said opportunities existed particularly within the healthcare and telecoms sectors, but was concerned about the prospects for certain banks and the utility sector, although he liked the insurance sector.

RETAIL GLOOM

With debt contagion sweeping through Europe and governments around the world implementing austerity measures, consumers are feeling the pinch.

FTSE small cap fashion retailer French Connection , down 15.5 percent, echoed Wednesday's announcement from video games retailer Game Group , and issued a profit warning.

Mothercare shed 17.9 percent after the FTSE 250 <.FTMC> mother and baby products retailer reported first-half pretax losses.

Investors, wary that the signs are not promising for retailers in the build up to the important Christmas trading period, sold out of positions in blue chip firms such as Marks & Spencer , Kingfisher and Next , which fell up to 1.7 percent.

Mixed retail data failed to lift sentiment in the sector.

The tough economic conditions in Europe saw brewer SABMiller's earnings fall short of expectations, pulling its shares down 1.8 percent.

On the macro economic front, there was slightly better news from the world's biggest economy.

New U.S. claims for jobless benefits hit a seven-month low last week, while permits for future home construction rebounded strongly last month, bolstering views the economy was gaining traction.

On the upside, Europe's largest drinks can maker Rexam rose 2.4 percent following its update, with Oriel Securities maintaining its add rating on valuation grounds.

National Grid , Britain's biggest energy distributor, added 2.4 percent after reporting a rise in first-half pretax profit and saying it was on track to deliver strong full-year results.

(Additional reporting by Tricia Wright; Editing by Mike Nesbit)