European banks were battered by mounting fears Greece is heading for a disorderly default and the debt crisis could spread to Italy, sending shares skidding more than 3 percent Tuesday to a two-year low.

Early losses were pared after Italy successfully sold short-term bonds and the panic eased. But bank stocks were still on the defensive and down over 10 percent in the last seven trading days as politicians have failed to find a fix for Greece and as investors fear this week's health check on 91 banks could show up more holes in the industry.

Euro zone finance ministers Tuesday said a flexible rescue fund to help Greece could buy back its debt, but they set no deadline to act and failed to calm investor nerves. They also declined to rule out the possibility of a selective default by Greece to make its debt mountain more sustainable.

Things are clearly going from bad to worse. It took too long to stabilize Greece and now the contagion is spreading. There is certainly a fundamental element in the worries about Italy. The debt load is high and growth is lackluster, said Philippe Gijsels, head of research at BNP Paribas Fortis Global Markets in Brussels.

By 0923 GMT the STOXX Europe 600 bank index <.SX7P> was down 1.1 percent at 172.6, after falling as low as 168.02, its lowest level since May 2009.

Italian bank Unicredit fell over 7 percent and Intesa Sanpaolo lost 4 percent, before turning higher aided by a short-selling ban by Italy's regulator and news Italy

had sold its targeted 6.75 billion euros of 12-month bills in a bond auction. By 0955 GMT Unicredit and Intesa were each up 2 percent.

Unicredit shares are still down by a fifth since July 1 as borrowing costs for Italy have soared on fears about the scale of the country's debt.

Alessandro Frigerio, fund manager at Milan's RMJ Sgr, said the recovery was helped after Economy Minister Giulio Tremonti said he would wrap up an austerity package.

Finding a solution is tough, but the markets are saying in a tough situation you have to take the devil by the horns... Right now we're in a phase that is not manageable anymore because Italy right now, when it goes to the market, has to pay 6 percent (in 10-year bonds) and that's a very, very difficult level, Frigerio said.

Andrew Lim, analyst at Espirito Santo in London, added. Italy and Spain have been thrown into the mix and they are far bigger in magnitude than Greece, Ireland and Portugal. This could be a true systemic crisis. This is a very real threat and the panic feeds on itself.

As borrowing costs rise, the repayment of debt becomes more costly to maintain and could lead to an economic slowdown and more losses for banks.

Barclays , BNP Paribas , Deutsche Bank , Lloyds , UBS and Credit Agricole all fell over 2 percent.

In Portugal banks also reversed steep early losses and were up over 1 percent in volatile trade. Shares in the country's largest listed bank Millennium bcp were up 1.2 percent on the day at 0.33 euros after a near 6 percent slump in early trade down to record lows of 0.305 euros.

Euro zone finance ministers Monday promised cheaper loans, longer maturities and a more flexible rescue fund to help Greece and other EU debtors in a bid to stop financial contagion engulfing Italy and Spain, but there are fears the rescue effort is unraveling. They will continue their meeting Tuesday.

They could have taken care of this a year ago, a month ago or a week ago. They didn't and now it's spreading to other markets, said Oon-Marc Valahu, a fund manager at Geneva-based firm ClairInvest.

The market fall could continue as long as uncertainty remained over how Europe's politicians would deal with the debt crisis, he said. The market hates instability and you can't stop the market from going down on fear.

The Institute of International Finance, which is leading talks on a private sector contribution to Greece's rescue, wants the EU to pledge to buy back debt to provide a longer term solution to Greece's mountain of debt, rather than just a quick fix.

The release of the result of a stress test on European banks is another worry. It could show holes in the capital position of some banks and analysts said another fear is that a weak test could fail to restore confidence.

We've got the solvency tests being released Friday, which is why everyone's a bit nervous. The market is short the banks, which has been an easy trade, said Andrew King, head of equities at BNP Paribas Asset Management, which has 551 billion euros in assets under management.


Some Spanish banks could fail the stress tests, Spain's Economy Minister Elena Salgado said Monday, backtracking from earlier comments that all Spanish banks would pass. This year's test will not include generic provisions -- funds set aside during good times to provide a buffer in bad times -- which will hurt Spanish lenders as they had 27 billion euros of generic provisioning at the end of March.

Six Spanish banks have failed the European stress tests, including five savings banks and one medium-sized bank, ABC newspaper said Tuesday, citing unnamed sources. The Bank of Spain declined to comment.

It depends who has failed -- it would have to be one of the medium-sized listed banks to have a big shake on the sector. Smaller savings banks failing would have less of an impact, said Tania Gold, analyst at UniCredit.

The impact of problems in Italy would be felt more widely. Overseas banks had $1.1 trillion of exposure to Italy at the end of December, with France's banks accounted for $389 billion of that, or 35 percent, according to data from the Bank for International Settlements.

(Additional reporting by Sudip Kar-Gupta, Atul Prakash and Simon Jessop in London, Sonya Dowsett in Madrid and Silvia Aloisi and Valentina Za in Milan; Editing by Dan Lalor and Mike Nesbit)