By Myles Neligan

WASHINGTON/LONDON (Reuters) - The Financial Services Authority imposed a temporary ban on short-selling financial stocks on Thursday, saying the measure was needed to prevent further instability in the financial sector.

The move came as New York began a probe into illegal short- selling of Wall Street firms and as the U.S. Securities and Exchange Commission toughened its short sale rules, in a crackdown on traders who bet stocks will fall.

Under the FSA ban, investors will be barred from taking new short positions or adding to existing ones in financial shares from midnight on Thursday Sept 18.

The ban will remain in force until January 16, 2009 and will be reviewed after an initial period of 30 days, the FSA said.

The move, the strictest major-market clampdown on short- selling to date, comes hours after British bank Lloyds TSB Group (LLOY.L: Quote, Profile, Research) agreed to buy rival HBOS HBOOY.PK in a rescue takeover following a dramatic fall in the HBOS share price earlier this week.

The measure underscores growing concerns that short-selling -- in which an investor sells borrowed stock in the anticipation the price will fall, allowing the stock to be bought back more cheaply -- has exacerbated sharp declines in UK banking stocks since the onset of the credit crunch.

The trading technique has also been cited as a cause of the recent fall in U.S. financial sector stocks.

STABILITY THREAT