Italian shares plunged and the country's cost of borrowing spiked this evening as euro zone ministers in Brussels scrambled to contain Europe's spreading debt crisis.
The main FTSE Mib index in Milan closed down almost 4% at 18,295 points, recovering slightly after plummeting more than 4% during trading.
Bank shares suffered the sharpest falls, with Italy's two biggest lenders, Intesa Sanpaolo and UniCredit, dropping by 7% and 5.2% respectively. Bank shares were temporarily suspended at one point. Other European markets and bank shares also fell heavily, with Germany's Commerzbank down 8.6% and French banks losing between 6% and 8%.
Investor concern rose further after German Chancellor Angela Merkel said she had told Italian Prime Minister Silvio Berlusconi to ensure Italy's parliament approves an austerity budget to send 'a very important signal' to the markets.
The Italian government earlier this month announced a four-year austerity budget worth €40 billion in a bid to reduce the budget deficit to just 0.2% of output by 2014 from 4.6% last year.
Some analysts have questioned whether the measures will be approved amid tensions in the cabinet and point out that many of the budget cuts are only scheduled to go into force after the government's mandate runs out in 2013. There are reported to be tensions between Berlusconi and his fiscally conservative Economy Minister Giulio Tremonti.
Italy is particularly exposed because it has one of the highest public debt levels in the world - 120% of GDP - and one of the lowest growth rates in Europe.
The long-term cost of borrowing for Italy rose to the highest level since the creation of the euro zone and the difference between Italian and German 10-year bonds - a key measure of investor risk - hit a record high.
The yield on Italian 10-year bonds jumped to 5.6% from 5.3% at the beginning of trading, following sharp rises on Thursday and Friday. Yields on Spanish 10-year bonds meanwhile rose above 6% from 5.7%.
Italy's credibility on financial markets has however been severely hit by recent months after Standard and Poor's and Moody's ratings agencies put the country on review for a possible downgrade of its sovereign credit rating.
After the defection of some of his supporters, Berlusconi is also ruling with a reduced majority in parliament and has suffered severe setbacks in some local elections and a round of referendums over the past few months.
Italy tries to curb short selling
Earlier, Italy's financial regulator imposed temporary curbs on short selling from today. The new measures, which apply until September 9, force investors with large short positions to declare them to the Consob financial market authority in a bid to avoid the volatility which dragged stocks down 3.5% on Friday.
Short selling means betting on the value of a stock falling. If used on a large-scale basis it can make the value of the stock market tumble and it was banned in many countries at the height of the global economic crisis.
'The measure reinforces the Consob's control powers during the current period of heightened volatility,' the regulator said in a statement.
Investors with positions equivalent to 0.2% or more of a company's capital must communicate these to the Consob. They will also need to declare to the regulator if these positions change by increments of 0.1% or more.
