European shares fell on Monday, dragged down by banks after Greece and its private creditors failed to come up with an agreement on a debt swap before the start of a European summit focused on growth and the region's debt crisis.
Investors are hoping for a deal to avoid a messy default by Greece, which could cause havoc in the financial system and hit company profits.
There were worries Portugal may follow in Greece's footsteps, with yields continuing to rise in the country. Italian yields also rose as the country, which is also in the forefront of the region's debt crisis, is set to test demand for longer-dated debt later in the session.
Banking stocks, many of which have exposure to euro zone peripheral debt, were the worst performers, with the STOXX Europe 600 Banks index .SX7P down 2.1 percent.
BNP Paribas, Societe Generale, and Credit Agricole, which are among the banks with large holdings to the region's peripheral debt, were the worst hit on worries they could be forced to make further writedowns if no solution is reached.
French banks were also hit by worries about a financial transaction tax in the country after President Nicolas Sarkozy said he would set a tax of 0.1 percent on transactions in French securities, with a government source saying it would target shares.
Athens will be a dominant focus in talks at the European Union summit, due to start at 10 a.m. ET, which is also expected to sign off a permanent bailout fund to help fight the debt crisis as well as focus on creating jobs and growth.
"It is all pretty negative, Greece is still trying to get a deal and there are worries about contagion,» said Joe Rundle, head of trading at ETX Capital. «The pressure will be on Italy today and it could struggle in its bond auction.
"Euro zone leaders still need to come up with a solution and all the negative news is not good for consumer confidence and could lead to a snowball effect, spending could slow down and hit company earnings."
By 4:39 a.m. ET, the pan-European FTSEurofirst 300 .FTEU3 index of top shares was down 0.8 percent at 1,031.96 points following making their first weekly loss since mid-December on Friday after US GDP figures came in below expectations.
The Euro STOXX 50 volatility index .V2TX, a key gauge of Europe's investor fear, jumped 9.3 percent to a weekly high on the region's debt concerns -- the higher the volatility index, the lower investor appetite for risk.
The FTSEurofirst 300 was holding above its October high at 1,028 - a level it broke through in mid-January, but ETX's Rundle said it could fall to 1,018, which was its 200-day moving average, a momentum indicator that defines possible support and resistance areas.
In another reminder of how countries were vulnerable to near-term monetary and financial shocks, Fitch downgraded the sovereign credit ratings of Belgium, Cyprus, Italy, Slovenia and Spain late on Friday.
"Policymakers have emphasized that Greece is unique, but markets are not convinced,» Societe Generale analysts said in a note.
"Placing greater financial clout behind the euro area rescue mechanisms with strong commitment to austerity and structural reform at the national level would go a long way to securing credibility.» [Reuters]