European stock markets slumped about 3%, as the value of the big banks retraced much of the gains they had made since a new rescue deal was agreed by Eurozone leaders last Wednesday.

The euro fell 1.5% against both the dollar and the pound.

Worry over the Italian government’s ability to finance itself remains at the heart of the crisis, as Rome’s cost of borrowing rose to new highs.

Banks drop back

Continental banks remain heavily exposed to the debts of troubled European governments, as well as a general flight of cash from the European banking system that emerged over the summer.

France was worst hit, with Societe Generale down 9.8% and BNP Paribas 9.6%, while in Germany Deutsche Bank dropped 8.6% and Commerzbank 8.5%.

The UK did not escape, with Royal Bank of Scotland down 7.8% and Lloyds 7.6%.

However, Europe’s banks still remain well above the lowest levels seen in the last two months.

As part of the new rescue deal, European Union leaders agreed that their banks must increase their capital – their buffer against future losses – by 108bn euros ($151bn: £93bn).

This will likely be done by issuing new shares, either to private buyers or to the governments themselves, something that is likely to dilute the value of existing shares.

Banks were also asked by European leaders to accept a 50% write-off of the debts owed to them by Greece.

However, the Greek Prime Minister, George Papandreou, announced after share trading had closed in Europe that he would put this agreement to a referendum, raising a question mark over whether it will go ahead.

Share prices on Wall Street – including shares in European banks that are traded there, such as Deutsche Bank – did not react to the news.

Self-fulfilling fear

Meanwhile, Italy’s 10-year cost of borrowing in bond markets has risen to 6.1%.

That is still slightly short of the highest level since Italy joined the euro, which was seen in early August, and prompted the European Central Bank (ECB) to start buying up Italian debt.

How is the European Central Bank helping the banks?

However, markets are rattled by the fact that Italy’s borrowing costs have crept up again despite the ECB’s intervention, and despite a revamp of the Eurozone’s bailout fund, intended to assist Italy.

Moreover, Italy’s shorter-term borrowing costs have risen even more sharply, to their highest euro-era levels.

Rome now has to pay 4.5% interest to borrow money for just one year, even though the German government must pay only 0.4% over the same period.

The difference reflects the potentially self-fulfilling fear of lenders that Italy may not be able to repay its large existing debt load unless it is able to re-borrow the money from markets as the debts come due for repayment.

There are also fears that Europe may be sliding back into recession, which would make Italy’s debts even harder to repay.