Italian financial markets slumped on Monday, with the spread between the 10-year bond yield and Germany's benchmark hitting a new record, as investors worried the country may become engulfed in Europe's debt crisis.
Traders fear Italy's banks will take heavy losses on the debt of bailed-out countries like Greece and that government debt will ultimately prove too big to manage without international help.
The bond spread hit 300 points, a record, before edging back slightly. The interest rate on a 10-year Italian bond was 5.64 percent by late afternoon, more than twice the 2.67 percent rate for the German equivalent, considered the safest in the eurozone.
In an effort to keep speculators at bay, the stock market regulator set a limit on short-selling _ when traders sell stocks they do not actually own in the hope of buying them back at a lower price.
But the measure, which runs through Sept. 9, failed to support stock markets much, with Milan's FTSE MIB index closing down 3.96 percent.
Banks led the decline _ Unicredit dropped by as much as 10 percent and Intesa Sanpaolo by 9 percent, before recovering a bit on closing. Fiat Industrial and Telecom Italian also were among the worst performers.
European Central Bank member Lorenzo Bini Smaghi noted Italian banks were heavily exposed to the sovereign debt crisis _ finance ministers in Brussels were discussing Monday how to get the private sector to contribute to the cost of bailout efforts.
"In Italy there is a strong correlation between sovereign debt and bank risk, because of the elevated public debt and because the banks are holding an important quantity of sovereign bonds," Bini Smaghi was quoted as saying by the news agency ANSA.
He said Italian banks were undercapitalized compared with their European counterparts and called for them to raise more cash soon.
The issue is a sensitive one as European financial regulators will reveal on Friday the results of stress tests on 91 EU banks. Mario Draghi, next to take the helm of the European Central Bank, expressed confidence last week that Italian lenders would pass the test, though markets are clearly jittery.
Beyond the banks, investors are also worried about the country's massive public debt, of nearly 120 percent of GDP, and poor growth prospects. Two ratings agencies have warned the country needs to get its public finances in order or risk a downgrade.
The government has introduced a euro48 billion ($68 billion) austerity package, now in parliament, to balance the budget by 2014. The market's reaction has been skeptical, however, with stocks and bonds falling steadily since its presentation last week.
Germany Chancellor Angela Merkel on Monday expressed confidence Monday that Italy will push through the plan.
"I have firm confidence that the Italian government will approve just such a budget ... and, in so doing, Italy will send a signal that it feels committed to consolidation and fighting debt," she said. "The euro in itself is stable, but we have a debt problem in some countries."
Just as Italy needs to project a strong political front, a rift has appeared between Premier Silvio Berlusconi and his finance minister, Giulio Tremonti, raising the specter of political instability.
Berlusconi in an interview with La Repubblica last week said that Tremonti was not a team player.
"He thinks he is a genius and everyone else is an idiot," Berlusconi said. "I put up with it because I've known him for a long time and that's how he is."
Tremonti has been embarrassed by a corruption probe into the activities of a former aide, and last week issued a statement saying he was giving up housing the aide had offered him for the nights he spends in Rome. Tremonti also had to make up with another minister after a microphone caught him calling Renato Brunetta "an idiot" during a press conference presenting the austerity measures.
The two tried to paper it over with a meeting later in the day, issuing a statement saying they had worked on pressing issues including the austerity budget and the government's efforts to balance the budget.
Berlusconi has kept a low profile since an appeals court Saturday ordered his family's investment arm to immediately pay euro560 million ($797 million) to a rival in a 20-year-old case involving corruption in the takeover of the Mondadori publishing house.