Banks with substantial peripheral euro zone bond holdings, and those that only scraped through the European Union's stress test of 90 lenders, started feeling the heat on Monday from investors anxious they should beef up their capital buffers.
The European Banking Authority (EBA) said late on Friday eight banks failed the test with a total capital shortfall of 2.5 billion euros ($3.5 billion).
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This amount -- puny in the broader context of European banking -- sparked a repeat of last year's accusations that the stress tests were again unrealistic given the euro zone's sovereign debt crisis.
The major shortcoming of the test was the lack of real stress applied to euro zone bonds held in long-term banking books. Adding in a realistic stress on peripheral euro zone bonds would add at least 20 billion euros to capital needs and maybe more than double that, analysts said.
By 0820 GMT the European bank sector was down 1.5 percent, hovering just above the two-year low hit last week. Intesa Sanpaolo <ISP.MI>, Unicredit <CRDI.MI>, Deutsche Bank <DBKGn.DE>, Societe Generale <SOGN.PA> and Barclays <BARC.L> all fell more than 3 percent.
Current market prices imply a much more severe loss than the EBA's assumption of a 15 percent loss on Greek bonds and a 1 to 2 percent "haircut" on Irish and Portuguese debt.
The EBA data showed banks held 98.2 billion euros of Greek bonds (67 percent held by domestic banks), 52.7 billion euros of Irish sovereign debt (61 percent held domestically) and 43.2 billion to Portugal (63 percent at home). Applying more realistic losses of 40 percent on Greek bonds and 25 percent on Portuguese and Irish debt would add over 45 billion euros to capital needs.
The knock-on effect on funding markets could be even more damaging, leaving attention fixed on how talks progress later this week on finding a solution to the Greek crisis.
"The European banking sector is captive to politics at the moment," said Hank Calenti, credit analyst at Societe Generale.
Euro zone leaders meet on Thursday in a bid to agree a second bailout for Greece and a package to address the broader fiscal woes of the euro zone that last week moved beyond Greece, Portugal and Ireland to Italy and Spain.
This broader package may include measures whereby banks agree to take a hit in some form on the sovereign debt they hold to give euro zone countries more breathing space to recover.
The EBA test, though flawed, did provide over 900 pages of data, including 250 on Spanish banks alone. "The key positive is greater understanding and recognition of sovereign stress," Huw van Steenis, analyst at Morgan Stanley, said in a note.
Banks could need between 40 billion euros and 64 billion of capital, based on a test overlaying the EBA's adverse scenario with a sovereign stress using implied losses from current market prices and a minimum core Tier 1 capital level of 7 percent, Morgan Stanley estimated.
Banks warned that too much transparency, such as news of BNP Paribas' <BNPP.PA> 24 billion euro exposure to Italy, may make markets even more jittery.
The banks that failed were small, nearly all untraded and mainly in Spain, where banking problems have long been known.
Sixteen banks scraped through the test and analysts expect them to come under market pressure to bring capital cushions up to scratch well before the EBA's April 2012 deadline.
They include Spain's Bankia -- which is planning a stock market listing on Wednesday -- Popular <POP.MC>, Sabadell <SABE.MC> and four more Spanish banks, along with Italy's Banco Popolare <BAPO.MI>, Greece's Piraeus <BOPr.AT> and Cyprus's Marfin <CPBC.CY>.
Portugal's biggest bank Millennium BCP <BCP.LS> also nearly failed the test and set the tone for swift action by saying late on Friday it would raise 400 million euros.
Europe's banks would need 41 billion euros to keep their core capital ratios above 7 percent, the global minimum from 2013 under the Basel III accord and already required by markets in practice, according to Reuters' calculations.
This compares with the 5 percent pass mark in the test.
JPMorgan analyst Kian Abouhossein said a tougher test of 27 of the bigger banks using EBA data would show 20 are a combined 80 billion euros short of capital.
His test applied a haircut to sovereign bond holdings in the banking book and required banks hold core capital of 7 percent.
Credit Suisse analysts said applying larger haircuts on peripheral euro zone bond holdings, including for Italy, as per current market prices, would leave a 45 billion euro deficit for 49 banks it tested.
Without market pressure, some banks may not top up capital levels as some local supervisors dispute test conclusions.
Germany's Helaba pulled out of the test just before the results were announced, disputing it would have been failed. The Bundesbank said it was happy with Helaba's capital position.
In Spain, the central bank says no lender needs to raise capital.
($1 = 0.708 Euros)
(Additional reporting by Sonya Dowsett in Madrid; Editing by David Holmes)