Moody's cut the credit ratings of two French banks on Wednesday because of their exposure to Greece's debt, highlighting growing risks to Europe's financial sector from a deepening euro zone sovereign debt crisis.
But the euro and European stocks were lifted by an announcement by the head of the European Commission that it would soon present options for issuing a common euro zone bond, despite huge political hurdles especially in Germany.
The ratings agency's one-notch downgrade of Societe Generale and Credit Agricole came hours before the leaders of Greece, France and Germany were to hold a video conference on measures to head off a potential Greek default, which has prompted rising global alarm.
China added its voice to U.S. concerns over Europe's apparent inability to stop debt contagion spreading, while Indian and Brazilian officials said major emerging economies were discussing increasing their euro sovereign holdings.
Moody's kept BNP Paribas on review for a ratings downgrade saying the bank's profitability and capital base provided an adequate cushion to support its Greek, Portuguese and Irish exposure.
France's biggest bank announced a plan to sell 70 billion euros in assets to help ease investor fears about leverage and funding that hit its two main rivals.
With senior EU and IMF inspectors due in Athens on Monday to check Greece's faltering compliance with its bailout plan, Chancellor Angela Merkel and President Nicolas Sarkozy were set to press Prime Minister George Papandreou to enforce harsh austerity measures to meet fiscal targets.
We want a guarantee that the recovery plan announced will be put into action, French government spokeswoman Valerie Pecresse said. No statement would be issued after the call.
While Europe's leaders struggle to avert a first default in the 12-year-old single currency area, the head of the European Union's executive challenged them to prepare for a great leap forward in fiscal integration that would be deeply divisive.
European Commission President Jose Manuel Barroso told the European Parliament that closer union, particularly in the 17-nation euro area, was the only way to reverse the negative cycle in financial markets.
Today I want to confirm that the Commission will soon present options for the introduction of eurobonds. Some of these could be implemented within the terms of the current treaty, and others would require treaty change, he said.
But he warned that such bonds, which face political and legal obstacles in Germany and other north European creditor states, were no silver bullet to end the crisis, and could only be part of a comprehensive plan.
A German Finance Ministry spokesman reaffirmed Berlin's opposition to the idea but said it awaited the proposals.
EU Economic Affairs Commissioner Olli Rehn said issuing common euro zone bonds would require much more intrusive surveillance of member states' fiscal and economic policies, which would have to be fully debated in each country.
STOP CRISIS SPREADING
China and the United States both voiced concern that euro zone governments may be losing control of the debt crisis.
Chinese Premier Wen Jiabao said Beijing was willing to help its biggest trading partner, but added that Europe must stop the crisis -- which now threatens Italy -- from growing.
What we have to take note of now is to prevent the sovereign debt crises from spreading and expanding further, Wen said on Wednesday in an apparent response to pleas to buy more euro zone government bonds.
Chinese state media said the EU should recognize Beijing's help with the debt crisis by giving China market economy status, which would give better protection against European anti-dumping penalties -- a major irritant.
Wen's comment echoed concerns voiced by U.S. President Barack Obama who earlier this week urged the big euro area states to take responsibility for supporting weaker members and called for a more effective coordinated fiscal policy.
A senior Indian official said finance ministers of Brazil, Russia, India, China and South Africa would discuss a Brazilian proposal to increase their holdings of euro zone bonds when they meet in Washington on September 22.
But Greece's deputy finance minister injected a note of skepticism, saying those countries had shown little or interest in buying short-term Greek debt despite invitations to do so.
Credit markets are factoring in a 90 percent chance Greece will default on its debts and they demanded the highest risk premium on Italian five-year bonds at auction on Tuesday since the country joined the euro in 1999.
Italian Prime Minister Silvio Berlusconi's government won a parliamentary confidence vote on a 54-billion-euro austerity package, which lawmakers were due to finalize later in the day. The moves have done little so far to stem doubts about whether the euro area's third-biggest economy can manage its debts.
Greece, Ireland and Portugal have all received EU/IMF rescue packages, but many see Italy as too big to bail out.
Italy is the key to contain this crisis. It is the last window of opportunity before a serious prospect of a meltdown of the euro, said Domenico Lombardi, president of the Oxford Institute for Economic Policy and a senior fellow at Washington's Brookings Institution.
Bank of France Governor Christian Noyer said the Moody's action on French banks was relatively good news, noting it put them on a par with other major European lenders regarded as healthy such as HSBC, Barclays and Deutsche Bank.
It's a very small downgrade and Moody's had a higher rating than the other agencies so it's just put them on the same level or slightly better than the others, Noyer said.
Some analysts and industrialists say a combination of a Greek default and a financial meltdown in Italy could engender a banking crisis akin to the 2007-8 global credit crunch and risk tearing the euro zone apart.
Greece has said it will run out of cash within weeks unless it gets the next 8 billion euro aid tranche in October to pay wages and pensions.
In a measure of Washington's concern, Treasury Secretary Timothy Geithner will attend a meeting of EU finance ministers in Poland on Friday -- his second trip to Europe in a week.
Geithner tried to shore up confidence in Europe's ability to solve the crisis, telling CNBC television the strongest euro zone states have the financial capacity to hold the currency area together.
There is no chance that the major countries of Europe will let their institutions be at risk in the eyes of the market, he said, adding the United States had an interest in seeing the crisis resolved because it was causing economic uncertainty.
They recognize that they have been behind the curve. They recognize that it will take more force behind their commitments.
Two unidentified banks tapped the European Central Bank for dollar funding on Wednesday in the latest sign of stress as U.S. money market funds and other traditional dollar providers cut back on lending to Europe.
(Additional reporting by Gilbert Reilhac in Strasbourg, Jan Strupczewski in Brussels, Anirban Nag in London, Harry Papachristou in Athens, Yann Le Guernigou and Daniel Flynn in Paris; Writing by Paul Taylor, Editing by Janet McBride/Mike Peacock)