The Finance Ministry draft said measures to stabilize financial markets would include a "ban on naked short selling of shares, including derivatives referring thereto." One government source, speaking on condition of anonymity, said this would cover all German shares.

Berlin stunned markets last week and drew criticism from its partners including close ally France by unilaterally suspending naked short selling in euro sovereign bonds and credit default swaps as well as stocks in some financial companies.

Only Austria followed suit and since most such trading in Europe takes place in London, the German measure is largely symbolic. Naked short selling involves selling securities without owning or borrowing the underlying assets in the hope of turning a quick profit by buying them back at a lower price.

Investor worries that the euro zone debt crisis may turn into a banking crisis drove world stocks and the euro sharply down on Tuesday while safe-haven German bonds hit a record high and US Treasuries rallied.

Highly indebted Italy was the latest euro zone country set to announce an austerity plan, worth 26 billion euros ($32 billion) over two years, despite concern that Europe-wide retrenchment may crimp global economic recovery.

The Italian cuts will hit public sector pay and recruitment, health spending and road building, and mean later retirement for some state workers and less funding for local government.

The pan-European stock index fell by as much as 3.4 percent to a nine-month low, with banking stocks hit by the Bank of Spain's weekend takeover of a small savings bank, CajaSur, after a failed merger with another regional lender.

US stocks tumbled 2 percent when Wall Street opened and the London interbank lending rate rose (Libor) to its highest since last July as banks became more wary of lending to European institutions.

Spanish analysts said savings bank consolidation has been long planned as part of efforts to rationalize the sector.

However, markets worry that more troubles in southern Europe will have knock-on effects for larger euro zone banks, which are owed billions by public and private borrowers in the region.

"The big challenge is to prevent the vicious circle, that means for example the crisis of the public sector turning into a banking crisis," European Central Bank governing council member Ewald Nowotny told a Brussels conference.

The dollar, seen as a safe haven from Europe's debt worries, gained 1 percent against euro and sterling. The euro briefly traded below $1.22, erasing most of the recovery from last week's four-year low.

The global financial system is showing signs of increased stress, though still well short of the panic that followed the collapse of investment bank Lehman Brothers in September 2008.

The two-year US bond-swap spread, a key gauge of financial system stress, rose to fresh one year highs near 60 basis points, up from 51 bps on Monday. It reached 160 bps in the weeks after the Lehman crash.

Shares in Europe and Asia were dragged lower by fears that austerity measures by European governments that piled up debt during the financial crisis will shackle a global recovery.

"There is indeed a risk that, under market pressure, some countries overdo austerity," Olivier Blanchard, chief economist of the International Monetary Fund, said in a newspaper interview. "That would be a mistake." European Union officials played down such risks.

European Council President Herman Van Rompuy told a Brussels Economic Forum: "In the short term, the acceleration of fiscal consolidation will hamper growth in the euro zone as a whole only marginally." European Economic and Monetary Affairs Commissioner Olli Rehn urged EU governments to combine "smart" budget cuts with structural reforms such as freeing up labor markets.

A former ECB governing council member, Slovenian European Affairs Minister Mitja Gaspari, said that unless euro zone states with healthier fiscal positions took steps to stimulate growth, the bloc might dip back into recession next year.

"The chance of a new (EU) recession is smaller than the chance of things moving for the better but bigger than we thought a few months ago," Gaspari told Reuters.

Even a $1 trillion pledge from European leaders has not been enough to calm fears that Greece's debt woes would spread to other deeply indebted nations, particularly in southern Europe.
 
ASIAN SLIDE

Concern at increasingly fierce rhetoric between North and South Korea over the sinking of a South Korean warship added to stock market nerves.

Banking sources said some of Europe's banks are looking at using government guarantees again to help raise money from the corporate bond markets which have been shut for more than a month by the sovereign debt crisis.

If markets stabilise, strong banks from France, Germany and Scandinavia - Europe's core - are expected to try to start issuing bonds again, but banks from southern Europe are likely to need support because of concerns over sovereign risk.

"Government guarantees are under consideration from a number of quarters more actively now than a few months ago," said a senior debt capital markets banker from a US bank.