By Tracy Rucinski and Stephen Jewkes
MADRID/MILAN (Reuters) - Spain and Italy reintroduced bans on short selling on Monday to discourage speculative trading after stock markets fell steeply in response to fears that Spain might need a full-blown bailout.
The two countries had both banned short-selling last year when markets were also volatile, but they had lifted the bans in February.
"Given extreme volatility in European stock markets that could disturb the orderly functioning of financial activity it is necessary to review stock markets' operations in order to ensure financial stability," Spain's stock market regulator CNMV said in a statement.
It said its decision to ban short selling had followed the ban by Italy, where regulator Consob said it was being reinstated because of the current situation affecting financial markets. French regulator AMF, which has banned short selling in the past, said it had no plans to follow suit.
The fears that Spain may need a full sovereign bailout triggered a broad sell-off on European shares, with the Italian and Spanish blue-chip indexes falling more than 5 percent to a record low before recovering.
Italian banks and insurance companies are under heavy pressure as Spain's woes drive Italian bond yields higher, depressing the value of the government bond portfolios held by Italian banks and insurers.
Shares in Italian banks recouped some of their heavy losses in late trading on Monday after the Italian market watchdog reinstated its short-selling ban.
By the close, the Italian banking index was down 1.3 percent. At 1200 GMT the index had been down 4.3 percent. Spain's banks recovered earlier losses, to close 0.8 percent higher.
The European banking index ended down 2.7 percent, while the FTSEurofirst 300 index finished 2.4 percent lower.
But stock market traders said the ban had also increased nervousness that the euro zone debt crisis might get worse.
"Every time they do short selling bans, it exacerbates the problem because people flee risk assets," Justin Haque, pan-European trader at Hobart Capital Markets said.
A London-based derivatives broker said: "(The ban) implies that regulators want to protect their shares, and particularly banking shares, and the speculation will therefore be they see things or have information that is not currently in the market."
Short-selling is a common way for hedge funds and other investors to bet on falling share prices. Traders borrow stocks to sell them in the hope of scooping them up later at a lower price and pocketing the difference.
The Spanish stock market regulator has banned short selling on all securities for three months, while Italy banned short selling on banking and insurance stocks until July 27. Both were effective immediately.
In Spain, the regulator said the ban, which will not apply to market-makers, encompasses any operation on stocks or indexes, including cash operations, derivatives traded on platforms as well as over-the-counter derivatives (ie financial instruments not traded on exchanges).
The CNMV also said it might extend the ban for another three months beyond October 23.
'Naked' short-selling, where traders do not even borrow the stocks before selling them, is not allowed under Spanish or Italian rules.
The European Securities and Markets Authority (ESMA), the European Union markets watchdog, will have coordination powers from November to impose short-selling curbs more widely to avoid distortions in share trading across borders.
It said on Monday it was informed of Italy's and Spain's decisions and had no further comment. Shares in many big companies are traded on several platforms and not just their national exchange.
(Additional reporting by Antonella Ciancio in Milan and Huw Jones, Simon Jessop and Francesco Canepa and Sudip KarGupta in London; Editing by Jon Loades-Carter and Jane Merriman)