The index was on track for its biggest daily drop since the turmoil in the banking sector in March, when Credit Suisse collapsed.

By 0802 GMT the index had recovered some losses, but remained down 2.2%, underperforming a broader index of European banks which fell 1.4% and the pan-European STOXX 600 which was down 0.1%.

Italian banks led losses in the sector. BPER Banca was last down 7.8%, while Intesa Sanpaolo fell 6.8% and FinecoBank Banca Fineco dropped 7.4%.

"The tax that Italy has levied on the excess profits that banks are perceived to be making has come as a surprise, and is likely raising concerns that over countries could follow Italy's example," said Stuart Cole, chief macro economist at Equiti Capital.

Only for 2023, Italy will tax 40% of banks' net interest margin, a measure of income banks derive from the gap between lending and deposit rates. The government expects to collect less than 3 billion euros ($3.29 billion) from the measure, sources close to the matter told Reuters.

Proceeds from the windfall tax will be used to help mortgage holders and cut taxes, the country's deputy prime minister said.

The cost of insuring against the risk of default for Italian banks rose on Tuesday. Five-year credit default swaps for Intesa Sanpaolo and Unicredit both rose to their highest since July 11, according to S&P Global Market Intelligence.

News that ratings agency Moody's on Monday downgraded the credit ratings of 10 U.S. banks by one notch was also seen as negative for the sector.

"It is the windfall tax without a shadow of a doubt, the U.S. news just adds salt in the mix and obviously does not help sentiment either," said Stephane Ekolo, an equity strategist at Tradition.

(Reporting by Lucy Raitano, editing by Alun John and Amanda Cooper)