European stocks fell sharply on Wednesday on the political uncertainty in Italy and whether a new government can tackle its debt mountain, which pushed Italian bond yields to a euro era record well above 7 percent.

A rally early in the session, caused by relief that Prime Minister Silvio Berlusconi had pledged to step down, quickly petered out.

Italy's benchmark FTSE MIB index tumbled 4.1 percent, with banking heavyweights Intesa SanPaolo and UniCredit , which have high exposure to sovereign bonds, falling 4.4 and 5 percent respectively.

The political situation in Italy is in a state of complete flux causing risk aversion by investors, said Richard Batty, strategist at Standard Life Investments, part of the Standard Life Group, which administers 196.8 billion pounds ($313 billion) of assets.

The market is fearful that we are going to go through a period of political instability and uncertainty not knowing who is going to be the next government, what type of government it's going to be.

Berlusconi said he would quit as soon as parliament passed budget reforms urged by European partners to help Italy stave off a debt crisis that is threatening the euro zone. His centre-right party is calling for elections, while the main opposition called for a national unity government.

Italy's bond yields shot above 7 percent, regarded as unsustainable. Italy, the euro zone's third-biggest economy, is often described as being too big to bail in contrast to other euro zone countries like Greece, which have received bailout packages in return for pledges on austerity measures.

Strategists said the European Central Bank was perhaps not buying Italian bonds aggressively to force its government to press ahead with its austerity measures.

The rise in yields tells us that ECB is not fully standing behind Italy. And why should it? Louise Copper, markets analyst at BGC wrote in a note.

At 1241 GMT, the FTSEurofirst 300 index of top European shares was down 2.1 percent at 963.20 points.

The index is down 14 percent in 2011. Although it is up more than 12 percent from a September low, strategists say a default by Italy could take the euro zone crisis, a major factor behind the decline for shares, to a new level and cause investors to stay clear of equities.

EARNINGS AND VALUATIONS

Euro zone banks' results, such as those of Societe Generale this week, have highlighted major losses caused by exposure to euro zone sovereign bonds.

In contrast, the U.S. results season is seen by analysts as having surprised more on the upside.

Although the United States also suffers from a debt mountain, strategists say growth prospects are healthier there.

Europe is likely in a recession, Credit Suisse says in a note, urging investors to especially be wary of cyclicals, a sector which it says may weaken further. It advises investors to buy U.S. equities.

However, the U.S. earnings outperformance may already be in the price. Equity valuations on Thomson Reuters Datastream showed the STOXX Europe 600 carrying a one-year forward price-to-earnings of 9.2, compared with 11.6 for the S&P 500 .

Among individual companies, Europe's biggest bank, HSBC , added to the gloom. Its shares fell 5.9 percent after it posted a drop in underlying profits, hurt by lower investment banking income.