ROME/ATHENS (Reuters) - Financial markets held their breath on Tuesday as Italian Prime Minister Silvio Berlusconi's reform-shy government teetered on the brink and debt-crippled Greece's leaders struggled to put together a national unity government.
Rome has displaced Athens as the epicenter of the euro zone's sovereign debt crisis, with government bond yields nearing unsustainable levels that could force the bloc's third largest economy to seek a bailout that Europe cannot afford.
Italian 10-year borrowing costs touched a new record of 6.71 percent on Tuesday, raising the risk that Rome's massive debt -- the second highest in Europe at 120 percent of gross domestic product -- could spiral out of control.
Now we are really reaching very dangerous levels ... We are above yield levels in the 10-year where Portugal and Greece and Ireland issued their last bonds, said Alessandro Giansanti, a rate strategist at ING.
Under massive pressure to resign, Berlusconi faced a crucial vote on public finances in parliament that could sink his center-right coalition if enough party rebels desert him.
Five lawmakers in his PDL party said they would abstain, putting Berlusconi's majority in danger. The main opposition parties said they would also abstain, allowing last year's budget to be approved while highlighting the government's weakness.
The 75-year-old billionaire premier, battered by a series of trials and sex scandals, may face a tough confidence vote this week even if he survives on Tuesday.
Euro zone finance ministers, meeting in Brussels, agreed on Monday on a roadmap for boosting the 17-nation currency bloc's 440-billion-euro ($600 billion) rescue fund to shield larger economies like Italy and Spain from a possible Greek default.
But with bond investors increasingly on strike, there are doubts about the efficacy of those complex leveraging plans.
Countries outside the euro area kept up a chorus of pressure for more decisive action to stop the crisis spreading.
The euro zone needs to show the world it can stand behind its currency, it cannot just wait on developments in Athens and in Rome, British finance minister George Osborne said.
We must also make progress here in Brussels. If we don't, that will continue to have very damaging effects on the entire European economy.
Swedish Finance Minister Anders Borg added: Europe is running dry on credibility and a solution to a high debt crisis must be lower debt. The responsibility for that falls with the country with high debt and that is obviously Greece and Italy.
Distress signals from the bond market and the European Central Bank showed the crisis is gathering pace alarmingly.
Shifts in the Italian yield curve and a widening gap between the prices bondholders demand for Italian debt and what potential buyers are prepared to pay are flashing warning signs similar to those seen in Portugal, Greece and Ireland before high borrowing costs froze them out of debt markets.
In a sign that they are increasingly cut out of money markets, the ECB reported that Italian banks needed 111.3 billion euros in central bank funding in October, up from 104.7 billion euros in September and a mere 41.3 billion euros in June.
Even the European Financial Stability Facility, the euro zone's bailout fund, had difficulty finding buyers for its top-notch AAA-rated paper on Monday, drawing barely enough bids for 3 billion euros of 10-year bonds issued to support Ireland.
EFSF head Klaus Regling cited a very difficult market climate and uncertainty about the fund's future profile as factors in the weak demand.
In Athens, wrangling continued to try to form an interim administration to save Greece from bankruptcy by enacting a second international bailout plan before early elections, after Socialist Prime Minister George Papandreou agreed to step down.
Early signs that a deal was within reach on a 100-day government to push the 130 billion euro bailout, including a voluntary 50 percent writedown on Greece's debt to private sector bondholders, through parliament by February appeared to be fading over the choice of prime minister.
Former ECB vice-president Lucas Papademos was in talks with ruling Socialist and conservative opposition leaders on heading the government, but one sticking point was whether members of the main opposition New Democracy party would join the cabinet.
In Brussels, the 27 European Union finance ministers were debating how to strengthen Europe's shaky banks to cope with the sovereign debt shock without halting lending to the real economy.
Options on the table included offering state guarantees to borrower banks or injecting cash into the European Investment Bank, the EU's soft-loan project finance arm, so that it can lend them more.
A bank recapitalization agreed at last month's EU summit will cost about 100 billion euros, the European Banking Authority (EBA) said, and some countries wanted a more flexible definition of capital to reduce the overall cost.
(Additional reporting by Emilia Sithole-Matarise in London, Sarah Marsh in Berlin, Valentina Za in Milan, John O'Donnell and Jan Strupczewski in Brussels; Writing by Paul Taylor, editing by Mike Peacock)