America's biggest banks were battling to head off an investor rout ­following fears that their battered finances would need a further boost from the US government.

Bank of America saw its share price slump 20% at one point before closing down 18% at $8.32, while Citigroup dived 18% and closed down 15.5% at $3.83. The falls wiped out the gains the two banks had made since a faltering recovery began in November.

Bank of America was locked in ­discussion with US treasury officials ­following its request for a loan. ­Meanwhile, Citigroup is expected to report its deepest quarterly deficit yet, after suffering net losses for four consecutive quarters.

The prospect of further write-downs on toxic assets held by the banks and a collapse in profits were blamed for the near panic selling in New York early in the session.

But the wider market recovered later in the day on hopes the seriousness of the situation would prompt further US ­government intervention. Speculation about a pending Senate vote on ­authorising the remaining $350bn (£238bn) from the government's financial bail-out fund helped the Dow close up 12 points at 8212.

Concerns that the US banking system was in bigger trouble than politicians and regulators had previously thought sent UK bank shares tumbling, dragging down the FTSE 100 index 1.4% to 4121.

Lloyds TSB plunged to its lowest value since 1989 following successive days of share price falls. The bank, which officially absorbs HBOS on Monday, crashed 11.69% to 103p.

Barclays was also hammered by a wave of selling to finish the day at 130.4p, down 8.23%. HSBC, which is believed to be under pressure to raise further capital, slipped 7% to 567p.

The share price falls posed a problem for Gordon Brown, who may be forced to bring forward plans for further rescue measures.

Proposals to package toxic assets into a single "bad bank" are not currently thought to be on the agenda, it is understood the Treasury is considering offering to underwrite a ­proportion of bank assets to prevent the need to raise further ­capital. The ­insurance policy would be paid for by the banks, but would avoid the need for the government to increase its share-holdings, which exceeds 50% in the case of Royal Bank of Scotland.

Ministers are keen to avoid full nationalisation of any bank, preferring at least a veneer of private-sector involvement.

But continued speculation that nationalisation is a real prospect in the US and the UK, coupled with what is in effect a freeze on dividend payments as a price for further government funds also ­worried investors, many of whom have hung on to their holdings through the worst of the credit crunch and were hopeful of a recovery later this year.

Economic data in recent days showing the US and Europe faced a long and deep recession appeared to be at the heart of the decision by investors to sell bank shares. Analysts said hopes of a recovery in the latter half of the year were hit by figures showing sharp declines in manufacturing output and services coupled with rising unemployment.

A prolonged recession would delay any recovery in the value of assets held by banks, in particular property, which is expected to continue falling this year and possibly into next year. Without a recovery in asset values, banks would be forced to make further write-downs.

Citigroup is expected to hive off riskier businesses as part of a rescue package, while Bank of America could be forced to sell parts of Merrill Lynch, the investment bank it bought last year.

Citigroup could create a "bank within a bank" to contain its worst-performing assets in an effort to protect the rest of the operation and allow a revival in lending. Unwanted assets worth as much as $600bn – a third of its asset base – could be ringfenced, according to US reports.

Nick Parsons, chief strategist at the capital-markets house NabCapital, said: "Many investors held firm last year and saw their investments decline by 30% or 40%. They have learned from that and when they see a longer recession looming they are more prepared to sell."