* Index falls to fresh 3-1/2-month low * Big banks offer support on strong earnings guidance * Hankyu Hanshin, Taiheiyo Cement surge on MSCI inclusion * Hokuhoku Financial, Hiroshima Bank slump on MSCI deletion By Dominic Lau TOKYO, May 16 (Reuters) - Japan's Nikkei average fell 0.9 percent on Wednesday as investors cut exposure to risky assets after the failure of Greek politicians to form a government raised the prospect leftists opposed to bailout terms could win new elections. Concerns over a slowdown in China, Japan's largest export market, after a report that new lending by China's four biggest state-owned banks was flat in the first two weeks of May, also weighed on the market. The pace of selling increase in the last 15 minutes of the morning session. By the midday break, the Nikkei was down 0.9 percent at 8,820.79. Earlier, it hit a 3-1/2-month low at 8,806.99. The broader Topix index dropped 0.9 percent to 740.93. One trader said an expected outflow of about $460 million from passive funds after an MSCI index review did not help the Japanese market in the short-term. However, the Nikkei could be ripe for a rebound as it was deep in "oversold" territory, with its 14-day relative strength index at 25.3. Thirty or below is considered oversold. Shun Maruyama, chief Japan equity strategist at BNP Paribas, said the short-selling ratio was at a critical level, an indication that the Japanese market could soon rebound on short-covering. "The past three to four days, the short-selling ratio in the Tokyo market went up to 27.9 percent... the highest level in the past few months," Maruyama said. "I guess short positioning has been accumulated ... in the shorter term, I am expecting a technical rebound on short-covering." Gains in Japan's top banks, after they forecast earnings above market expectations, lent some support. Sumitomo Mitsui Financial Group rose 0.5 percent and Mizuho Financial Group gained 2.6 percent. Hankyu Hanshin Holdings Inc climbed 5.6 percent and Taiheiyo Cement Corp advanced 5.4 percent after MSCI said they would be put in the MSCI All Country World Index after the close on May 31. The other inclusion was Nexon Co Ltd . In turn, Hokuhoku Financial Group Inc, Hiroshima Bank Ltd < and Nippon Sheet Glass Co Ltd would be removed from the benchmark. Their shares fell between 2.2 and 8.1 percent. Exporters came under pressure, with Toyota Motor Corp , Honda Motor Co, Canon Inc and Panasonic Corp down between 1.6 and 2.7 percent. Trading volume on the main board after the halfway point was relatively light, at 45 percent of its full daily average for the past 90 days. INCREASINGLY DOWNBEAT The Nikkei has fallen 14 percent since hitting a one-year peak of 10,255.15 on March 27 on concerns over slowing global growth and the euro zone debt crisis, and global investors have turned increasingly downbeat on Japan. A monthly survey of asset managers by Bank of America Merrill Lynch showed investor allocation in Japanese stocks fell to 19 percent net underweight this month from 10 percent in April. It was 4 percent net underweight in the March poll. "The message from U.S. investors was that, since emerging market equities offer higher yields than those of advanced countries with better growth prospects and more healthy public finances, they are preferable to Japanese equities," Merrill Lynch said in a report. "U.S. investors also criticised Japanese companies for their overly cautious earnings forecasts, and in the latest survey the evaluation of Japan corporate earnings (good minus bad) again worsened, from 6 percent to -2 percent." Of the 168 Nikkei companies that have reported January-March earnings so far, 61 percent have either beat or met market expectations, Thomson Reuters StarMine data showed.