LONDON ? 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 0.5 percent to $1.4036.
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 further, in contrast to most other large economies.
The rate on ten-year Italian bonds spiked up 0.31 percentage point to 5.98 percent even though the Italian Parliament has backed an austerity package designed to get the public finances back on an even keel. The Spanish rate rose 0.24 percentage point to 6.31 percent.
Last Friday's stress tests have so far been met with a degree of skepticism by investors as they did not take into account any sovereign default. 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.
The banks were required to reveal their exposure to the government debt of ailing countries like Greece, 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.
After all, Greece is expected to be judged to be in default by credit rating agencies if banks are involved in a second bailout of the debt-ridden country. On Thursday, EU leaders will hold an emergency meeting to discuss the terms of the second bailout.
The 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 bank's finances ? in the hope that analysts would use that clarify the banking system's state of health, even if the EU couldn't bring itself to consider the possibility of default.
Bank and brokerage analysts are now doing just that. Royal Bank of Scotland analysts, for instance, said that if everyone had to account for the fallen value of shaky bonds now on their books, 57 of the 90 banks would have to raise euro91 billion ($130 billion) in capital to meet a tougher 7 percent capital buffer.
Still, German and Spanish officials, who had two and seven banks, respectively, that barely passed, said they did not see the need for their banks to raise more capital and questioned the assumptions of the tests.
Amid the uncertainty, bank shares across Europe took a hammering. Italy's Banco Popolare, which barely passed the test, was down 4.2 percent; France's Credit Agricole fell 2 percent, and Germany's Deutsche Bank dropped 2.8 percent. The retreat wasn't just isolated to countries that use the euro ? Britain's Barclays fell 3.3 percent.
The worry in the markets is that this week's EU 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 has been pressing for the involvement of the banks in the bailout, will attend the summit. She had earlier indicated she would not if a final deal on Greece was not likely.
In an interview with Financial Times Deutschland, the ECB's president Jean-Claude Trichet said the bank would not accept defaulted Greek bonds as collateral, potentially cutting off funding from the country's banks.
"If a country defaults, we will no longer be able to accept its defaulted government bonds as normal eligible collateral," he told the newspaper.
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.
Greece's debt pile is so large that many experts believe it will have to default in some way eventually. So far the country has focused on austerity measures, but that approach has also been weighing on much-needed economic growth and fueled tensions in Greek society.
Strikes and demonstrations are a daily occurrence. On Monday, taxi drivers blocked road access to the country's main airport and harbor at the height of the tourism season to government reforms.
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McHugh contributed from Frankfurt, Germany.
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