Worries that Europe's debt crisis will spread to Italy and Spain spooked investors Monday after stress tests into the continent's banks failed to ease tensions ahead of an emergency meeting of EU leaders.
In afternoon trading, most of Europe's main stock markets were sharply lower, with bank shares hit particularly hard, while the euro fell 0.6 percent to $1.4041.
In a sign that contagion fears have not been allayed by last week's European bank stress test results, yields on Italian and Spanish bonds ratcheted up, in contrast to most other large economies.
The rate on ten-year Italian bonds spiked up 0.25 percentage point to 5.92 percent, having earlier jumped above 6 percent, even though the Parliament backed an austerity package designed to get the public finances back on an even keel. The Spanish rate rose 0.15 percentage point to 6.23 percent.
Last Friday's stress tests have so far been met with a degree of skepticism by investors, partly because they did not take into account any sovereign default.
The banks were required to reveal their exposure to shaky government debt but analysts said it would have been better if the European Banking Authority had simulated the impact of a default in its test scenarios to better judge the system's strength.
"On the face of it, the tests highlight that the European banking sector is in better health than expected, although crucially investor concern will remain over the credibility of the tests given that the tests did not include an assessment of the impact of sovereign defaults," said Lee Hardman, an analyst at the Bank of Tokyo-Mitsubishi UFJ.
Only eight of the 90 banks tested failed and were pushed to raise euro2.5 billion ($3.5 billion); five were from Spain, two were Greek and one was Austrian. Sixteen barely passed, however, and may face pressure to strengthen their finances by raising new capital _ the idea behind the exercise.
Shoring up the banks is a key part of Europe's battle against its government debt crisis, since a default by Greece or another ailing country could inflict losses on banks, requiring government bailouts and choking off credit to the economy.
Greece is expected to be deemed in default by credit rating agencies if banks take losses in a second bailout for the country. On Thursday, EU leaders will hold an emergency meeting to discuss the terms of such a deal.
The stress tests required banks to show they could maintain a financial buffer in a downturn: at least 5 percent of loans, bonds and other investments. Regulators required disclosure of a large amount of data on banks' finances to allow analysts to make their own conclusions on the sector's health _ since the EU couldn't bring itself to consider the possibility of default.
Royal Bank of Scotland analysts, for instance, said that if all the banks had to account for the fallen value of distressed bonds now on their books, 57 of the 90 tested would have to raise euro91 billion ($130 billion) in capital to meet a tougher 7 percent capital buffer.
Still, German and Spanish officials said they did not see the need for their banks to raise more capital and questioned the assumptions of the tests. Germany had two banks that barely passed and Spain had seven.
Amid the uncertainty, bank shares across Europe took a hammering. Italy's Banco Popolare, which barely passed the test, was down 6.7 percent; France's Credit Agricole fell 3.6 percent, and Germany's Deutsche Bank dropped 3.4 percent. The retreat wasn't just isolated to countries that use the euro _ Britain's Barclays fell 3.7 percent.
The worry in the markets is that this week's meeting will fail to come up with concrete measures to deal with Greece amid growing signs of a split between the European Central Bank and the German government in particular.
German Chancellor Angela Merkel, who will be at the summit, has been pressing for the involvement of the banks in the bailout.
But the ECB's president, Jean-Claude Trichet, insists the central bank would not accept defaulted Greek bonds as collateral, potentially cutting off funding for Greece's banks.
"If a country defaults, we will no longer be able to accept its defaulted government bonds as normal eligible collateral," he said in an interview with Financial Times Deutschland.
Trichet added that governments would then be responsible to provide their own backstop for the Greek financial system if the country is considered to be in default on its debts.
The ECB said Monday that it had made no effort last week to prop up bond markets through its securities purchase program, the 16th straight week it has left the measure idle.
McHugh contributed from Frankfurt, Germany.