By 1030 GMT the European bank index was down 6.1 percent at 133.2 points. The index gave up all the gains made on Thursday, when banks staged their biggest rally for 18 months after EU leaders and banks agreed to write off half Greece's debt as part of a wider euro zone rescue plan.
If Greek voters reject the unpopular bailout plan it could result in a "hard default," which could force banks to take losses of about 75 percent on their Greek sovereign bonds, trigger payouts on credit default swap insurance contracts, and raise the threat of a systemic risk, said Andrew Lim, banking analyst at Espirito Santo in London.
"If we get a hard default in Greece, it will exacerbate the situation with Italy and Spain. It just increases the problem of Italy going down the same route, and that's the real risk," Lim said.
Greece's referendum is expected to take place in a few weeks, adding uncertainty about the bailout to a febrile mood in the European financial sector. Last week's deal had raised hopes a line could be drawn under banks' Greek losses and euro zone bonds could be sold to China and other investors.
A hedge fund manager specialized in euro zone debt said: "The Greece referendum has completely undermined the euro zone's ability to sell EFSF bonds. The Chinese can't invest in any euro zone fund while the question in Athens remains unanswered. (The) same goes for progress on a haircut and banks."
Prime Minister George Papandreou said he needed wider political backing for the 130 billion euro ($181 billion) bailout, but there is a strong chance voters will reject it.
Shares in France's Societe Generale tumbled 13 percent and BNP Paribas and Credit Agricole fell more than 10 percent. They are among the most exposed to Greece through sovereign debt holdings and loans.
Italy's Unicredit and Intesa Sanpaolo shed 11 percent and Germany's Deutsche Bank and Commerzbank lost 8 percent. Insurers were also caught up, with ING and AXA both losing 11 percent.
Greek sovereign bonds were last trading at about 37 percent of their face value, indicating investors face a loss of 63 percent on their holdings.
Private sector investors, including the likes of BNP Paribas and SocGen, face a 103 billion euro loss on their holding of 206 billion euros of sovereign bonds under last week's plan, but would lose another 26 billion based on current market prices.
Banks in France and Germany are most exposed to Greece, and there are concerns lenders will take hits on loans to companies and homeowners if the economy unravels. Credit Agricole, for example, had 27 billion euros of loans to Greece at the end of last year through its Greek subsidiary.
The bigger worry is the risk the crisis will spread to Italy and its huge bond market. Unicredit held 47 billion euros of domestic sovereign bonds at the end of last year.
Yields on Italian 10-year bonds rose to 6.2 percent on Tuesday.
"The Greek move makes it all the more important that Italian and Eurozone policymakers, including those from the ECB, build a reliable firewall around Greece to prevent more serious contagion to Italy," said Holger Schmieding, economist at Berenberg Bank. ($1 = 0.717 Euros)
(Reporting by Steve Slater and Dominic Lau in London, Edward Taylor in Frankfurt and Lionel Laurent in Paris; Editing by Jane Merriman and Hans-Juergen Peters)