* FTSEurofirst 300 up 0.7 pct, Euro STOXX 50 up 0.9 pct
* Italian banks rise as country's bond yields drop
* Market rally shows signs of exhaustion
By Blaise Robinson
PARIS, March 1 (Reuters) - European stocks were higher early Thursday afternoon, led by bank shares benefiting from the European Central Bank's latest liquidity boost while a dip in Spanish borrowing costs at an auction fuelled hopes the worst of the euro zone crisis is over.
Gains were limited, however, as a number of benchmark indexes in Europe and on Wall Street failed to convincingly break above major resistance levels as a brisk 2-1/2 month rally loses steam.
The FTSEurofirst 300 index of top European shares was up 0.7 percent at 1,082.98 points at 1225 GMT, while the euro zone's blue-chip Euro STOXX 50 index was up 0.9 percent at 2,534.98.
The STOXX euro zone bank index surged 2 percent, with Italian lenders pacing the gains while the country's 10-year bond yields fell below 5 percent for the first time since August.
Banco Popolare gained 5.6 percent, UBI Banca added 4.3 percent and UniCredit climbed 4.4 percent.
"Saying that the funding operation would be 'unlimited' was a game changer from the ECB. It suddenly meant no more risk of bank bankruptcy," said Philippe Delienne, head of Convictions AM, which has 702 million euros ($935 million) under management.
"Now that the financial system has been stabilised, there is a lot of money to make on both bank bonds and shares. Italian yields will fall below 4 percent, no doubt."
On Wednesday, the ECB provided 530 billion euros cheap funding to banks, boosting investor optimism that more credit will flow to businesses, government borrowing costs will ease further, and risky assets will rally.
The ECB's first long-term refinancing operation (LTRO) in December had been a major factor behind the new-year rally in European equities, sending valuation ratios to levels not seen in 10 months.
Also on Thursday, Spain sold 4.5 billion euros of government bonds, with an average yield on the 2015 bond of 2.617 percent from 3.332 percent the last time it was sold on Feb. 16. The 2016 bond sold at an average yield of 3.376 percent, compared with 3.455 percent when it was last sold on Feb. 2.
"Demand was strong for all lines and the average yield was lower than at their previous auction, confirming the positive trend for Spanish debt," said Annalisa Piazza, market economist at Newedge Strategy, in London.
"Yesterday's three-year LTRO ... certainly supported today's auction. We expect further tightening in cross-country spreads in the coming weeks and a positive outcome of this week's EU summit might also be supportive."
Within the banking sector, investors were targeting names from within the euro zone while dumping shares of Swiss banks such as Credit Suisse, down 1.7 percent, and a 1.1 percent lower UBS.
Also bucking the trend, Vivendi tumbled 7.6 percent after slashing its dividend and warning of a drop in core profit of up to 15 percent at its SFR telecom business, hit by tougher competition in the French mobile market.
Around Europe, Britain's FTSE 100 index was up 0.6 percent, Germany's DAX index up 0.7 percent, and France's CAC 40 up 0.8 percent.
The three benchmark indexes, along with the FTSEurofirst 300 and the Euro STOXX 50, remain below February highs.
"After recent records on U.S. indexes, a sideways consolidation is shaping up. Once again, the key is to see if the S&P 500 will be able to break above 2011 highs," said Gerard Sagnier, technical analyst at Aurel BGC, in Paris.
Earlier this week, the S&P 500 closed above 1,370, its May 2011 intraday high, but failed to further rise, and retreated on Wednesday. (Editing by Dan Lalor)