"Portugal is weighing on the market. The market cannot see a solution to the problem of European debt," a Milan-based trader said.
Portugal's Millennium bcp shed 5.1 percent and Banco BPI dropped 4.3 percent, while Spanish banks, which have significant exposure to Portugal, also came under pressure, down 1.9 percent.
Spanish banks' exposure to Portugal stood at $84.6 billion at end-December, according to Bank for International Settlement data, more than twice the exposure of German and French banks.
"Moody's lowering its rating on Portugal is punishing Spanish banks. They have a certain exposure to Portugal, above all more than other European countries, and that harms them," a trader in Madrid said.
Banco Santander , Spain's biggest bank, lost 1.8 percent and BBVA dropped 1.9 percent.
In Italy, UniCredit shed 4.7 percent, Intesa Sanpaolo fell 3.5 percent and Banco Popolare eased 3.4 percent.
Greek bank shares fell 2.7 percent and are down 22 percent as a whole this year after losing 53 percent in 2010.
The Thomson Reuters Peripheral Eurozone Bank index fell 3.4 percent, underperforming a 1.6 percent drop in the STOXX Europe 600 banking index.
The cost of insuring bank debt against default also rose, with the iTraxx Senior Financials index up by 7 basis points to 167 basis points.
Cormac Leech, bank analyst at Canaccord Genuity, said a sharp widening in sovereign credit default swap spreads implied a higher probability of default and increased chance of the periphery separating from core Europe.
A default or a break-up of the euro zone would create a huge capital deficit for all the banks affected, he said.
"On top of that funding costs increase as general bond yields increase since, as sovereign yields go higher, investors ask themselves 'why should I buy bank debt when I can get a decent yield buying sovereign debt?'," he said
Copyright Reuters, 2011