Equities hammered by euro zone and banking worries

Traders look at screens at the Madrid bourse September 5, 2011.

LONDON (Reuters)- European stocks tumbled 4 percent on Monday, with banks plumbing a more than two year low, as fears for the future of the euro zone bubbled up against a background of weak economic growth and threats to the banking sector.

The euro fell across the board, with peripheral euro zone debt concerns and political uncertainty in Germany prompting rises in both the dollar and safe-haven Swiss franc.

Worries about public deficits in Greece and Italy and a regional election rout for Germany's ruling party cast fresh doubt on the euro zone's ability to tackle its debt crisis.

Wall Street was closed for a holiday but it was unlikely that U.S. investors would have been in any more of a positive mood given data ahead of the long weekend that showed U.S. employment growth halted in August.

That fueled concerns that the world's biggest economy is slipping back into recession.

It prompted oil to sell off on Monday, with benchmark Brent dropping below $110 a barrel.

The euro zone, meanwhile, faces a week packed with political and legal risks, beginning with a German constitutional court ruling on Wednesday on claims that Berlin is breaking German law and European treaties by contributing to bailouts for Greece, Ireland and Portugal.

The court is not expected to rule against the contributions, but may add stipulations for dealing with future requests that will complicate the region's bailout plans.

"People are pricing in the risk of European meltdown, rather than the likely outcome," said Ian King, head of international equities at Legal & General.

Banks in Europe were also under the cosh because of uncertainty about what a U.S. lawsuit connected to the packaging of toxic mortgage debt might mean.

"Not a great start to the week. There is a lot going on for banks, especially in the light of a low-growth environment and the backdrop in the euro zone not improving," said Mike Lenhoff, chief strategist at Brewin Dolphin.

The MSCI all country world equity index was down 2.0 percent on the day, helped along by Japan's Nikkei losing 1.9 percent in a catchup from Friday's U.S. jobs data.

European stocks closed down 4.06 percent, with the banking sector shedding nearly 6 percent to a 29-month low.

"There is massive tailrisk in the system right now," said Andrew Lim, banks equity analyst at Espirito Santo.

BATTERED EURO

The dollar rose half a percent to a one-month high against a basket of major currencies.

The euro fell across the board, hitting a three-week low of $1.4111 and dipping 1 percent against the safe-haven Swiss franc.

As many European financial institutions are saddled with losses on bond holdings, traders are also worried that their funding could face more strains, putting pressure on the single currency.

The yield premiums investors demand to hold Italian and Spanish 10-year government bonds rather than benchmark German Bunds hit their highest levels in a month.

As pressure mounted on Italy -- the euro zone's third-largest economy -- to get its fiscal house in order, Italian 10-year yields rose close to 5.6 percent, their highest since early August.

Recent buying by the European Central Bank had pushed them down to the 5 percent level.

Besides the German court ruling, a meeting of finance ministers of Germany, the Netherlands and Finland will be closely eyed as they discuss the nagging issue of collateral for loans to Greece.

Debate over the effectiveness of ECB bond-buying is likely intensify at the bank's monthly policy meeting on Thursday.

"We will probably get the ... assertion that 'all euro zone countries must stick to their fiscal plans as agreed with the euro zone authorities'," Richard McGuire, rate strategist at Rabobank, said.

"Singling out Italy -- there is a risk that that would be counterproductive because it would put Italian yields under significant pressure and therefore undo much of the work that the ECB has done."

(Additional reporting by Simon Jessop and Ana Nicolaci da Costa; Editing by John Stonestreet)