(REUTERS) - Worries over the health of Europe's banks hit European stocks on Wednesday after Italian lender Unicredit was forced to price a rights issue at a huge discount, and the euro fell after a benchmark German bond auction left markets unimpressed.

UniCredit launched a 7.5 billion euro ($9.8 billion) two-for-one rights issue at 1.943 euros per share, a discount of 69 percent to its closing share price on Tuesday.

The capital increase, meant to shore up its ravaged balance sheet sent shares in Italy's largest bank by assets down by 9 percent.

European stock markets, which fell early on Wednesday to break a four-session rally, moved further into negative territory, with the FTSEurofirst 300 index falling about 0.5 percent.

Banking stocks, many of which are heavily exposed to euro zone debt, were down about 1.5 percent.

Whatever way you slice and dice it, UniCredit's discount is much bigger than for the other banks and that being the case, I think it's come as a bit of a shock to some investors, and I think some of them are just bailing out, said Andrew Lim, banks analyst at Espirito Santo.

GERMAN DEBT SALE UNDERWHELMS

Meanwhile Germany sold 4.057 billion euros ($5.30 billion) of 10-year government bonds in its first auction of the benchmark maturity since one last November that raised fears Europe's debt crisis had begun to threaten its biggest economy.

Bids for the Bunds amounted to 1.3 times the amount offered and were improvement over the previous sale. The debt sold at an average yield of 1.93 percent, lower than the 1.98 percent from November, when market nerves contributed to one the country's least successful debt sales since the introduction of the euro.

It looks solid - there's nothing surprising. (The bid/cover ratio) was above one, which the market will see as a decent start for the year, said Achilleas Georgolopoulos, a strategist at Lloyds Bank in London.

The sale was much better than November's auction, but not particularly great either, added Peter Chatwell, rate strategist at Credit Agricole.

The auction kicked off a huge sovereign refinancing cycle in the euro zone, with traders worried that debt-laden countries such as Italy and Spain may have to pay unsustainably high prices to meet their needs.

The single currency slipped 0.5 percent to $1.2990, after gaining as much as 0.9 percent on Tuesday to reach its highest in a week at $1.3077 in the wake of a better-than-expected U.S. manufacturing report.

In a separate sign of stress in the Eurozone banking sector, commercial lenders' overnight deposits at the European Central Bank hit a record high of 453 billion euros, data showed on Wednesday.

However, key Eurozone bank-to-bank lending rates continued to drop, pulled down by the ECB's recent record injection of almost half a trillion euros of ultra-long and ultra-cheap three-year liquidity.

Eurozone banks received 489 billion euros late last month in the first of two opportunities to access the long-term loans.

EUROZONE SLUMP STILL LOOMS

The latest set of purchasing managers' indexes (PMIs) for the Eurozone and several key individual countries suggested the region remains on track for a moderate recession despite a slight uptick in the data for December.

The uplift in the Eurozone PMI in December does little to dispel fears of the region sliding back into recession, said Chris Williamson, chief economist at Markit.

The slight PMI improvement was due mainly to an upturn in Germany, widening the divisions between the region's stronger economies and the likes of Italy and Spain that appear to be undergoing a severe contraction.

Eurozone inflation eased from last year's peaks of 3.0 percent in December, the first sign of a fall in price growth this year that analysts expect will create room for more ECB interest rate cuts to help the weakening economy.

On the other side of the Atlantic, minutes on Tuesday from the last meeting of the Federal Reserve's policy setting committee, the FOMC, showed some members had noted that current and prospective economic conditions could warrant additional policy accommodation.

The Fed said it would begin publishing forecasts on the path of interest rates later this month, a move that could suggest rates will be on hold for longer than previously expected, which markets saw as dollar-negative.

Oil prices held steady around below $112 a barrel on Wednesday, as Iran again threatened to choke off crude shipments through the strategic Strait of Hormuz in retaliation against tougher sanctions from the West over its nuclear program.

Brent February crude fell 0.5 cents to $111.50 barrel after rising more than 4 percent on Tuesday to settle at the highest since Nov. 15.