George Osborne has floated the possibility that Greece might need to be sacrificed to save the euro after a fresh day of jitters on the world's financial markets saw Spain's long-term borrowing costs hit their highest level since the launch of the single currency.

In a highly unusual step, the chancellor suggested that Greece may have to leave the eurozone so Germany could convince voters that it was worth pouring more money into the troubled currency. Speaking at a summit of chief executives organised by the Times newspaper, Osborne said: "I ultimately don't know whether Greece needs to leave the euro in order for the eurozone to do the things necessary to make their currency survive.

"I just don't know whether the German government requires Greek exit to explain to their public why they need to do certain things like a banking union, eurobonds and things in common with that.

"I would suspect that if you had a eurozone finance minister here, they wouldn't really know the answer to that."

The cabinet was again briefed on the state of UK contingency plans, an issue that Osborne is likely to address in his annual Mansion House speech on Thursday.

There is some suggestion that Osborne thought his remarks were off the record.

His comments came as hopes faded that the weekend announcement of a €100bn (£81bn) bank rescue package would be enough to bring an end to the two-and-a-half year crisis as anxiety about developments in Greece, Italy and Cyprus as well as Spain gripped financial markets.

Osborne also expressed unhappiness with the way the rescue package for Spain's banks was organised. "What is depressing … is that everyone said to the eurozone that if you do not directly recapitalise these banks, if you do it via the Spanish sovereign, then you are not going to convince the market that the Spanish sovereign is entirely credible … and yet they went ahead down this route."

Interest rates on Spanish bonds rose to 6.8% on Tuesday, a rate not seen since the pre-euro days of the 1990s, the spread between German bonds widened to a record 537 basis points and the cost of insuring Spain against a debt default reached an all-time high. Investors fear Spain's cocktail of economic, financial and banking problems will see it frozen out of world markets.

Markets were also unsettled by opinion polls from Greece suggesting that the anti-austerity Syriza coalition was on course to win the most seats in this weekend's election. Reports from Greece suggested that up to €500m (£400m) was leaving the country in capital flight each day, while dealers expect neighbouring Cyprus to become the fifth eurozone country to need external financial support.

Italian bond yields were also on the rise, affected both by contagion effects from Spain and by comments from the Austrian finance minister, Maria Fekter, that Rome would be the next eurozone capital seeking a bailout. "Italy has to work its way out of its economic dilemma of very high deficits and debt, but of course it may be that, given the high rates Italy pays to refinance on markets, they too will need support," she said.

The remarks brought a furious rebuke from the Italian prime minister, Mario Monti, who said they were "completely inappropriate" for an EU finance minister.

Although Fekter sought to back-pedal by saying she had no indication that Italy was planning to seek a bailout, yields on Italian 10-year bonds tracked the upward move in Spain and stood at more than 6.2% by the close of business in Europe.

Stock markets seesawed on a day of jittery trading overshadowed by concerns that Spain's package would not be sufficient to draw a line under Europe's debt crisis. A late rally, helped by an early rise in shares on Wall Street, saw the FTSE 100 index of leading London shares close 41.37 points higher at 5473.74.

The euro was little changed for the day versus the US dollar, at about $1.2475, after a slump on Monday. "Investors will likely continue to sell the euro into strength, especially with Greek elections on Sunday and a European Union summit next week, which should be heavy in headlines," said Camilla Sutton, chief currency strategist at Scotia Capital in Toronto. "Any euro rally should prove short-lived."

The rise in Italian bond yields led to fears about the strength of the country's banks, with their shares suspended at one point because of the extent of their falls. Unlike Spanish banks, they are not exposed to huge losses on property loans that have turned sour but are a potential cause for concern because of their holdings of domestic Italian debt.

"We don't think Italian banks are in a similar situation [to Spain's] because their exposure to the real estate sector is more contained, and also because we don't see the risk of a sharp decline in Italian real estate prices like there was in Spain," Standard & Poor's primary credit analyst, Renato Panichi, told Reuters.

The misery for Spain continued when Fitch downgraded 18 banks following its downgrade of the country's sovereign rating last week. Fitch is concerned that the weak Spanish economy would continue to cut business volumes "which, together with low interest rates, will place pressure on revenues".

"Banks are being challenged to further increase loan-impairment coverage levels for real estate assets, while complying with stringent capital requirements. Some institutions are more vulnerable than others," Fitch said of Spanish banks.