The US legal moves are aimed at recouping billions of dollars lost in the financial crisis.
Share prices were weighed down by worries about weak US economic growth following disappointing jobs data, while the euro fell against the dollar as traders exited risky deals amid renewed eurozone debt concern, analysts said.
The head of the European Central Bank Jean-Claude Trichet warned on Monday of an urgent and imperative need for enactment of the framework of a second debt rescue for Greece, and for tightened discipline in the management of
eurozone economies.
And the head of the International Monetary Fund Christine Lagarde repeated her warning that banks in Europe need extra capital to withstand any contagion from the eurozone debt crisis.
ECB data showed that eurozone banks have deposited record amounts of overnight funds with it, a signal of reluctance by banks to lend to each other.
In early trading, London's FTSE 100 index of top shares dropped 1.62 percent to 5,206.09 points, but the main indices in Germany, France, Italy, Spain and Switzerland were down by 3.0 percent or slightly more.
"The US decided to drop a bombshell on the banking sector ahead of their extended weekend by announcing a $200-billion (141-billion-euro) lawsuit across the whole industry for the miss selling of mortgage backed assets, the dreaded subprime loans," said Simon Denham, head of London-based trading group Capital Spreads.
"When the sector is still just about in recovery mode these lawsuits have sent shockwaves through the sector and the overall financial markets sending Europe into a tailspin."
US authorities on Friday sued 17 top US and foreign banks over "billions of dollars" in losses on mortgage-backed securities that plunged in value in the 2008 financial crisis.
The European banking sector was a sea of red in Monday trading, as Deutsche Bank plunged 6.8 percent to 24.25 euros, Societe Generale dived 4.51 percent to 21.16 euros and Barclays plummeted 5.78 percent to 155.64 pence.
The Federal Housing Finance Agency alleges that in some cases lenders committed fraud in selling nearly $190 billion in securities to mortgage giants Fannie Mae and Freddie Mac, which had to be bailed out by the US government.
US firms targeted in the suits included Bank of America, Goldman Sachs, Citigroup, JPMorgan Chase, Morgan Stanley, General Electric, Ally Financial and First Horizon.
The foreign banks were Deutsche Bank, HSBC, Credit Suisse, Barclays, Nomura, Royal Bank of Scotland and Societe Generale.
Banking shares dived "as pressure mounts from US regulators over the selling of toxic mortgage debt," said Manoj Ladwa, senior trader at ETX Capital.
He added that Europe's main indices, which had already closed sharply lower on Friday, "look set for another leg lower ... as the market factors in the impact of zero job creation in the US for August."
Only 17,000 private-sector jobs were added in the US economy last month, down from a revised 156,000 in July.
The Labor Department said the unemployment rate remained unchanged at 9.1 percent from July. The number of unemployed people was essentially unchanged, at 14 million.
The jobs data for August were the worst since September 2010, when the economy shed more than twice the number of jobs it created. The pace of job growth remains far below the numbers needed to reduce the high unemployment rate.
Despite the weak US economic situation, the dollar rose against the euro on Monday as risk appetite was eroded by renewed worries over Greek debt. The European single currency is seen as a riskier bet compared with the dollar.
The euro dropped to $1.4147 from $1.4205 late in New York on Friday. The dollar edged up to 76.83 yen from 76.80 yen on Friday. US markets were shut on Monday for a public holiday.
- AFP /ls
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