European banking stocks fell sharply Tuesday before starting to rebound, with Unicredit and Deutsche Bank among the early losers, as fears that sovereign debt crises in peripheral euro zone countries might spread into the continent's larger economies and trigger a more widespread banking crisis.
Earlier on Tuesday, Dutch Finance Minister Jan Kees de Jager admitted to reporters at the meeting of European finance ministers that a selective default on Greek debt was no longer off the table.
Markets fear that Italy, the fourth-largest economy in Europe with debt of 120 percent of gross domestic product, will be drawn into the sovereign debt crisis. Unicredit shares were suspended in Milan as they hit limit down early Tuesday morning, but rebounded later in the day. Shares in Intesa San Paolo , the retail bank, continued Monday's downtrend in early trading.
By midday the Italian banks had recovered their losses after the country successfully sold 6.75 billion euros ($9.40 billion) of one-year paper. Yields jumped by 150 basis points to 3.67 percent, the highest level since September 2008. The bid-to-cover ratio was 1.55.
Killik & Co analyst Paul Kavanagh told CNBC.com that renewed fears of a European sovereign debt crisis becoming a fresh banking crisis had been driving the stocks down in the morning.
"The question is probably being asked about whether we're going to have another banking crisis," Kavanagh said.
"A lot of the banks are being held together based on assumptions of a fairly stable environment. I don't think anyone was pricing in another crisis into their stress tests. I think they were making assumptions about house prices, but I'm not sure this was part of their stress tests – what if we have a complete implosion of European credit, which of course would have some contagion effects," he added.
Markets are not waiting for the results of the European Union's banking stress tests on Friday, Kavanagh said, as few have much trust in a process seen to be too lenient.