UPDATE 1-Turkey's Halkbank says U.S. charges represent 'unprecedented overreach'

Turkey's Halkbank said on Wednesday that U.S. charges against it are part of sanctions Washington slapped on Ankara over its military incursion in Syria and represent an "unprecedented legal overreach." U.S. prosecutors on Tuesday charged the state-owned lender with taking part in a multibillion-dollar scheme to evade U.S. sanctions on Iran. In response, Halkbank's shares plunged as much as 7% on Wednesday despite a ban on short selling.

The indictment came a day after Washington imposed sanctions on Turkish officials, hiked tariffs and halted trade talks in an effort to persuade Ankara to stop attacks against the Kurdish YPG militia in northeastern Syria. The charges in a U.S. district court in New York, which further strains ties between the NATO allies, alleges Turkey's second-largest state bank conducted fraud, money laundering, and other sanctions offenses.

"These were filed as part of the sanctions introduced against our country by the U.S. government in response to Operation Peace Spring, heroically launched by the Turkish army to secure our borders and establish peace in the region," Halkbank said of the incursion now in its eighth day. Turkey's second-largest state bank said it did not engage in sanctions violations as alleged and falls outside of the U.S. Justice Department's jurisdiction since it has no branches or employees in the United States.

"Therefore the decision to indict is an unprecedented legal overreach," it said. The case against Halkbank follows from a previous criminal case that came to light in 2016 against Turkish-Iranian gold trader Reza Zarrab, who was accused of playing a central role in the sanctions evasion scheme.

Mehmet Hakan Atilla, a former Halkbank deputy general manager, was arrested in New York the following year and was later sentenced to 32 months in prison. He returned to Turkey in July after serving out his sentence. Zarrab pleaded guilty and testified for U.S. prosecutors. He said Iran, with the help of Halkbank and Turkish government officials including President Tayyip Erdogan, used a web of shell companies and sham transactions in gold, food and medicine to sidestep U.S. sanctions.

Turkey cast that case as a political plot against Erdogan's government and said it was an extension of a 2013 domestic corruption investigation, which Ankara says was launched by the network of Fethullah Gulen, a U.S.-based Muslim cleric. "The Halkbank case has always been on the table as political leverage," said a banking analyst who declined to be named.

MARKETS ON EDGE Before Turkish markets opened, authorities banned short selling on seven large Turkish bank stocks including Halkbank. Selling shares in the banks only to buy them later in the session was also banned, authorities said.

State banks - which have sold dollars to defend the lira since the Syria incursion began last week - were on Wednesday squeezing funding in an offshore FX swaps market to cushion the blow from the Halkbank indictment, a bond trader said. Halkbank stock nonetheless fell as much as 7.2% at the open and was down 4.8% at 0939 GMT.

The main banking index, which has fallen more than 16% this month on fears of U.S. repercussions, was down 2.4% while Turkey's broader stock index was off 1.3%. Turkey's incursion into northeast Syria has tested its ties with the United States and could imperil it's economy's recovery from last year's currency crisis. It came after President Donald Trump's abrupt decision to withdraw U.S. troops from the area.

The Kurdish YPG, which spearheaded the U.S.-backed Syrian Democratic Forces, was the main U.S. ally in the fight against Islamic State. Turkey's lira has declined some 10% against the dollar this year, due largely to worries that Washington would sanction Ankara over its purchase of Russian missile defense systems.

But the currency has firmed this week since the U.S. sanctions were announced and deemed lighter than expected. After the Halkbank indictment, the lira was up 0.3% at 5.9015 against the dollar. INTERVENTIONS

Following the Halkbank charges, the Borsa Istanbul said its CEO temporarily banned short-selling in banking shares within the top BIST-30 Index. The Capital Markets Board said it would protect investors and promote market stability. The banking analyst called it "a sort of intervention on the free market" and said authorities were motivated not only by Halkbank but the 8% fall in bank stocks on Monday.

Sadrettin Bagci, another bank analyst, at Deniz Yatirim, said Halkbank had the ability to absorb a possible fine of between $1.3-2.3 billion, depending on the capital measurement. "We think that a possible direct fine has been largely priced at the share price," he said.

The U.S. sanctions and increased tariffs risk slowing Turkey's recovery from recession after last year's crisis chopped nearly 30% off the value of the lira. The crisis was set off by concerns over deteriorating U.S.-Turkey ties and political interference in monetary policy. State banks stepped in to sell dollars in March when the lira briefly tumbled, and traders said they intervened again in the last two weeks.

The bond trader said they turned attention on Wednesday to the one-week FX swap market, where rates jumped to 20.25% and tested a 2-1/2 month high hit earlier this week. The Turkish stocks covered by the short-selling ban are: Akbank, Garanti Bank, Halkbank, Is Bank, TSKB, VAKIFBANK, and Yapi Kredi Bank.