European debt fears hit markets

In afternoon trading, most of Europe’s main stock markets were sharply lower, with bank shares hit particularly hard, while the euro fell 0.6 percent to $1.4041.

In a sign that contagion fears have not been allayed by last week’s European bank test results, yields on Italian and Spanish bonds rose, in contrast to most other large economies.

The rate on 10-year Italian bonds spiked up 0.25 percentage point to 5.92 percent, having earlier jumped above 6 percent, even though the Parliament backed an austerity package designed to get the public finances back on an even keel. The Spanish rate rose 0.15 percentage point to 6.23 percent.

Last Friday’s stress tests have so far been met with a degree of skepticism by investors, partly because they did not take into account any sovereign default.

The banks were required to reveal their exposure to shaky government debt 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 crucial 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.

Only eight of the 90 banks tested failed and were pushed to raise $3.5 billion; five were from Spain, two were Greek, and one was Austrian. Sixteen barely passed, however, and may face pressure to strengthen their finances by raising new capital - the idea behind the exercise.

Shoring up the banks is a key part of Europe’s battle against its debt crisis, since a default by Greece or another country could inflict losses on banks, requiring government bailouts and choking off credit to the economy.

Greece is expected to be deemed in default by credit rating agencies if banks take losses in a second bailout for the country. On Thursday, EU leaders will hold an emergency meeting to discuss the terms of such a deal.

The stress 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 banks’ finances to allow analysts to make their own conclusions on the sector’s health - since the EU couldn’t bring itself to consider the possibility of default.

Royal Bank of Scotland analysts, for instance, said that if all the banks had to account for the fallen value of distressed bonds now on their books, 57 of the 90 tested would have to raise $130 billion in capital to meet a tougher 7 percent capital buffer.

The worry in the markets is that Thursday’s meeting will not bring concrete measures to deal with Greece amid growing signs of a split between the European Central Bank and the German government in particular.