Fears of an escalation in the eurozone crisis and a new global recession sent stock markets falling sharply across Europe on Monday.

As pressure mounted on Italy to meet its budget commitments, the yield on its bonds jumped to new highs, while news that Germany's ruling party lost another regional election in the state of Mecklenburg-Western Pomerania – chancellor Angela Merkel's fourth straight regional election defeat this year –cast doubt over Europe's ability to agree on a solution to the debt problems. This follows Friday's news that European Union officials had interrupted talks on an aid package for Greece as it had fallen behind in cutting its budget deficit.

The FTSE 100 fell another 3.5% to close at 5102.58, down 189.45, while France's Cac and Italy's FTSE MIB both lost more than 4% and Germany's Dax dropped nearly 5% to its lowest level in more than 22 months. The euro touched a three-week low against the dollar.

Angus Campbell, head of sales at Capital Spreads, said: "The same old worries and uncertainty that have been haunting the markets over the past year and a half returned today, reminding investors that the European debt crisis is still the biggest single threat to the global economy.

"The political losses for Germany's leader over the weekend have thrown into question the ability of the eurozone's biggest economy and ultimate paymaster to be able to ratify all the bailouts that have been gifted around in recent months."

With Wall Street shut for the Labour Day holiday, trading volumes were thin however.

A poor UK service-sector survey also undermined confidence and raised new fears of a global recession, as did comments from Christine Lagarde, International Monetary Fund chief, who warned that the world economy was on the brink of a new crisis.

"We see that there has been, particularly over the summer, a clear crisis of confidence that has seriously aggravated the situation," she told Germany's Der Spiegel. "Measures need to be taken to ensure that this vicious circle is broken."

Lagarde warned that Europe's banks needed to be recapitalised, to give them protection from losses on their reserves of sovereign debt. The former French finance minister also argued that Europe needed to implement closer fiscal union and speed up its economic growth – which has almost ground to a halt.

"The sovereign debt issue weighs on the confidence that market players have in European banks," Lagarde said.

Financial stocks and miners led the fallers in London. Royal Bank of Scotland slid 12% to 21.78p; Barclays fell 6.6% to 154p, and Lloyds Banking Group lost 7.4% to 30.65p. The UK banks were buffeted by uncertainty over whether they will be forced to ringfence their retail and investment banking operations, as well as worries about US lawsuits relating to their role in the US sub-prime scandal.

Mining stocks fell following a report showing that growth in China's services sector fell to its lowest level since November 2005. Joshua Raymond, chief market strategist at City Index, said this had alarmed traders.

"China has been one of the bright spots in an otherwise anaemic global economic recovery and should that bright spot start to dim, which August's PMI data may be showing, it is likely to have stronger ramifications for global growth, considering China is the world's fastest-growing economy," Raymond said.

The rush from equities into "safe-haven" government bonds pushed the interest rate on German bunds to below 1.88%.

Concerns over the weak American jobs market also dogged investors, following the shock news last Friday that no new jobs were created in the US last month. Chris Weston, institutional trader at IG Markets, said Friday's disappointing non-farm payroll numbers continued to cast a shadow.

"That US non-farm payroll reading certainly left traders with little to celebrate on Friday, pushing markets on both sides of the Atlantic sharply lower as a result. This has certainly set the pace for Asian markets too and with Wall Street closed today for Labour Day, it seems unlikely that there will be much appetite to start taking on any risk just yet," said Weston.

"Even those who thought a dire jobs report would pave the way for another round of cheap money in the form of QE3 [a third round of quantitative easing] seem to be cooling on the idea – or at least any hope that it'll provide the same shot-in-the-arm response for equity markets."