By Helen Reid
LONDON/MILAN (Reuters) - European shares fell for a second day on Tuesday on fears a new election in Italy, which could become a proxy referendum on its euro membership, might renew the risk of a euro zone break-up.
Italy's main stock index (.FTMIB) closed down 2.7 percent and hit a 10-month low.
Italian Bank shares <.FTIT8300> slumped 4.9 percent to a fresh 13-month low, bruised by a sell-off in Italian government bonds, a core part of the banks' portfolios.
Banco BPM (BAMI.MI), Banco Generali (BGN.MI), Unicredit (CRDI.MI) BPER Banca (EMII.MI), fell between 5 percent and 6.7 percent.
"It's a market that is totally in panic", said Giuseppe Sersale, a fund manager at Anthilia Capital Partners, who noted "a total lack of confidence in the outlook for Italian public finances" as Italian bonds suffered their worst day in more than 25 years.
Italy's president set the country on a path to fresh elections, appointing a former International Monetary Fund official as interim prime minister with the task of planning for snap polls and passing the next budget.
After inconclusive elections in March, two anti-establishment parties dropped a coalition plan at the weekend after the president vetoed their choice of a eurosceptic to become economy minister.
Investors fear a polarizing election campaign which could deliver a deeply eurosceptic government, threatening the bloc's cohesion.
Rating agency Moody's said Italy was likely to be downgraded if the next government pursues "insufficient" fiscal policies and the uncertainties over Italy's future direction caused Sentix's euro zone break-up index to climb to its highest since April 2017, when investors feared a eurosceptic Le Pen presidency in France.
The pan-European STOXX 600 (.STOXX) fell 1.4 percent, with the euro zone's banks index (.SX7E) losing 4.5 percent, its biggest daily drop since the Brexit vote in June 2016.
The stress spread to other peripheral euro zone markets, with bourses in Madrid and Lisbon losing 2.5 percent and 2.6 percent respectively with bank stocks firmly in the firing line.
Banco Comercial Portugues (BCP.LS) fell 8.1 percent, while Spain's Sabadell (SABE.MC) lost 6.8 percent.
JP Morgan analysts repeated their earlier call for investors to move out of Italian equities and into Germany.
While German government bonds have been acting as a safe haven for investors, with yields on the euro zone benchmark bond falling, Germany's DAX (.GDAXI) shed 1.5 percent as investors fled risky assets.
Outside of politics-driven moves, British retailer Dixons Carphone (DC.L) plunged 21 percent after a profit warning. The new chief executive said the company needed to close stores at a time of a contracting UK electrical market.
(Reporting by Helen Reid, Danilo Masoni and Julien Ponthus; Editing by Alexandra Hudson)