Spain's prime minister, Mariano Rajoy, tried Monday to reassure clients of Bankia that their savings in the country’s fourth largest bank were safe.

Rajoy insisted that Spain’s banks would not need a bailout by the European Union.

Investors weren’t convinced.

Shares in Bankia fell and Spain’s borrowing costs rose as bond markets demanded higher interest rates to compensate for the increased risk of Spanish default.

"There will be no rescue of the Spanish banking sector," Rajoy told a press conference.

But at the same conference, Rajoy called for the eurozone bailout fund — the European Stability Mechanism — to be given additional powers to rescue distressed lenders directly, in addition to its existing authority to help national governments.

"Lots of people are in favour of that, and I certainly am," he said.

Earlier this month, Spain effectively nationalized Bankia by converting €4.5 billion in rescue funds it gave last June into shares.

Bankia shares fall 28%

The bank has been burdened by €32 billion ($ 41 billion Cdn) in bad loans after the collapse of the country’s real estate market.

"We took the bull by the horns because the alternative was collapse," Rajoy said today.

The lender's shares lost 28 per cent at the open but closed down 13 per cent in Madrid on Monday, at €1.37. It was  Bankia's first day back on the stock exchange following its announcement Friday that it would need the €19 billion ($24.4 billion) in state aid to shore itself up, a far bigger bailout than expected.

On Monday, the euro was trading at $1.2542 US.

The request came on the same day as credit rating agency Standard & Poor's downgraded Bankia and four other Spanish banks to junk status because of uncertainty over restructuring and recapitalization plans.

Spain’s central bank estimates show the country’s lenders hold some €180 billion ($231 billion) loans that could cause go bad.

The government fears the cost of rescuing the country's vulnerable banks could overwhelm its own finances, which are already strained by a double-dip recession and an unemployment rate of nearly 25 per cent, and force it to seek a rescue by the rest of Europe.

Concerns about how Spain plans to fund the bailout of its banks push the yield on its 10-year bonds 0.13 of a percentage point to 6.42 per cent.

Rajoy dismissed the rise as having more to do with worries over whether Greece would be forced by its high debt to exit the eurozone.

"There are major doubts over the euro zone and that makes the risk premium for some countries very high. That's why it would be a very good idea to deliver a clear message there's no going back for the euro," he said.

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Spanish Prime Minister Mariano Rajoy Monday called for the eurozone bailout fund to be allowed to rescue distressed lenders directly. (Pierre-Philippe Marcou/AFP/Getty )

A rate of seven per cent is considered unsustainable over the long term and there is concern that Spain might soon be pushed join the ranks of Greece, Ireland and Portugal and seek an international bailout.

The Prime Minister said that the government had not yet decided how it would proceed in funding the Bankia bailout.

However, the Economy Ministry said earlier Monday that it is considering injecting government debt into Bankia's accounts.

The bank could then turn to the European Central Bank and use those bonds as collateral to receive cash for the recapitalization.

Analysts said that such a technique would only prove to investors that the country is having difficulties raising money on the international debt markets and would therefore make them even more reluctant to buy Spanish debt.

"It sends a signal of a lack of confidence," said Mark Miller of Capital Economics in London.

Oscar Moreno of Madrid brokerage Renta4 said the government has little choice: either use this uncommon technique or simply ask the European Union for money to bail out the banking sector — which Rajoy has vehemently ruled out as unnecessary.

Moreno said Bankia's share price drop — and the rising bond yield — showed investors the Spanish banking sector's woes are getting worse. Only last week, for instance, Economy Minister Luis de Guindos said the government would inject about €9 billion into Bankia.

'It sends a signal of a lack of confidence.'—Mark Miller, Capital Economics

"Basically, what the investor sees is that, with what has emerged with Bankia, more money is going to be needed than what was originally stated" than in two government decrees ordering banks to put aside a total of some €80 billion in provisions to cushion against losses from real estate, Moreno added.

Spain's rocky financial situation has been made worse due to overspending by its semiautonomous regions.

One of the regional governments, Catalonia, called for financial assistance last week, claiming it was running out of options to refinance its debts.

Asked about the fragile state of finances of some of Spain's regions, Rajoy said, "We are not going to let any region or financial entity fall because otherwise the country would fall."

Concern about the health of Europe's banks is a key constituent of the region's financial crisis.

While Spanish banks suffer mainly from soured real estate investments, they and their counterparts across Europe also hold massive amounts of shaky government bonds. As the financial crisis worsens, those bonds lose value, hurting the banks.

The big fear is that if Greece eventually leaves the euro, confidence in other financially weak countries like Spain and Italy could fall, causing the value of their bonds to drop. Ultimately, the worry is that could undermine confidence in the system and create bank runs.

To avert such a disastrous scenario, financial experts are increasingly calling for a Europe-wide support system for the banks.

With files from The Associated Press