U.S.-based State Street Corp pulled out of British government bond auctions on Wednesday, a sign banks are shying away from markets they once queued up to support and a potential new stress for countries struggling to raise money.

Although the number of banks taking part in bond auctions has risen sharply in the past few years, many are now reassessing the risks they previously absorbed as the price of good relations with governments.

State Street blamed tighter financial regulation making the bond market a tougher place to make money, but the move also comes as the European debt crisis increases the risk of being left holding unsold sovereign bonds, and as banks are forced to become more cautious.

Overnight, State Street Bank in Boston has announced its withdrawal from various global cash bond trading activities, which includes UK government bonds, Britain's Debt Management Office said in a statement on Wednesday.

Banks designated as a primary dealer -- known as a gilt-edged market maker (GEMM) in Britain -- commit to buying a certain percentage of government-issued bonds in return for a guaranteed chance to participate in the auction.

It was once a coveted position, and banks often subsidised bond sales in the hope it would curry favour with governments, leading to lucrative business, such as privatisations of state-owned companies.

But scarce capital means banks are less willing to take on the increasing risk of being left with unsold bonds, and many in the market expect a shake-out in this crowded market.

A State Street spokeswoman said that increasing regulation such as the Volcker rule -- which prohibits U.S. banks from gambling on financial markets with their own capital -- was making bond trading a much harder business.

This decision was precipitated by the potential impact of the Volcker rule that may prohibit flow trading in certain government bonds, she said. State Street only became a UK primary dealer in September.

Other rules meant that European banks would need to hold much higher capital buffers, which would make it a far more costly business, she added. The bank had also left its other primary dealership, in Germany.

State Street has been keen in recent years to boost revenue in areas traditionally dominated by investment banks, such as market making and executing trades.

But its withdrawal marks a refocus on its core business of providing custody and fund administration to its brokerage, fund management and hedge fund clients.

CROWDED OUT

Sovereign bond auctions have seen a sharp rise in number of banks taking part. A small country like Austria, for instance, has primary dealer relationships with 24 banks, and several banks have mandates from more than 10 countries.

Most major U.S. investment banks and large European banks participate in the market. BNP Paribas , Deutsche Bank and HSBC are the biggest players. Dozens of smaller players may also have one or two mandates.

After the departure of State Street, Britain will have 21 banks left in its government bond auctions, the DMO said, compared with 15 two years ago.

The country gives primary dealership the exclusive right to participate in its bond auctions if they promise to purchase at least 2 percent of issuance and to play an active role in distributing and marketing UK government debt.

If more banks walk away, the loss of guaranteed buyers will likely boost costs for cash-strapped countries in Europe, making life more difficult just as they plan to issue 800 billion euros (670 billion pounds) of debt next year alone.

Many primary dealers are taking measures to mitigate risk from holding sovereign bonds, such as short selling bonds ahead of an auction and asking for stronger guarantees, which can drive up costs for governments.

Italy last month paid a record 6.5 percent to borrow six-month money, and its longer-term funding costs soared far above levels seen as sustainable.

And Germany saw a disastrous bond auction on November 23, with the central bank forced to pick up 39 percent of the intended volume, to prevent the sale from failing.

(Additional reporting by Tim Castle, Fiona Shaikh and Luke Jeffs; Editing by Dan Lalor and Andrew Callus)