Investors were jolted by the news that Dubai World, which is thought to have debts totaling around $60bn (about £35bn), has asked creditors if it can postpone its forthcoming payments until May. That has stoked fears of a potential default and contagion around the global financial system, particularly in emerging markets.

The announcement drove up the cost of protecting emerging-market sovereign debt against default.

Moody’s Investors Service and Standard & Poor’s cut the ratings on Dubai state companies, saying they may consider Dubai World’s plan to delay debt payments a default.

Several European banks, including Barclays in the UK, could potentially lose money in the debacle, which comes as many financial institutions are still recovering from the 2008-09 economic crisis.

“Investors view this (debt problem) as shockingly bad news,” said Rob Whichello, an analyst at French bank BNP Paribas.

Russell Jones, head of fixed-income and currency research at RBC Capital Markets in London, added: “Dubai isn’t doing risk appetite any favours at all and the markets remain in a vulnerable state of mind. We’re still in an environment where we’re vulnerable to financial shocks of any sort and this is one of those.”

The London Stock Exchange’s FTSE-100 index of leading shares lost 170.68 points, or 3.2%, at 5194.13 – its biggest one-day percentage fall since the market plunged to six-year lows in March. Trading was halted for more than three hours during the middle of the session because of a technical glitch.

Germany’s DAX fell 188.85 points, or 3.2%, to 5614.17 while the CAC-40 in France was 129.93 points, or 3.4%, lower at 3679.23.

Standard Chartered fell 93p, or 5.8%, to 1514p and HSBC has lost 35.6p, or 4.8%, to 705.6p. The two banks are heavily exposed to the region. Barclays ended 25.2p, or 7.9%, easier at 291.1p and Royal Bank of Scotland fell 2.77p to 32.99p, a loss of 7.7%. Lloyds Banking Group retreated by 5.42p to 5.7p. In Frankfurt, Deutsche Bank slid by 6.3% – 3.18 cents to €46.65.

Meanwhile, London Stock Exchange shares closed 60p lower at 754p – a drop of 7.3% – as traders fretted about a 20.56% stake in the company owned by Borse Dubai.

Sterling dropped more than 1% against the dollar, while the euro hit a one-month high against the pound, again on fears of UK banks’ exposure to Dubai. UK gilts and other European government bonds rose as investors fled to the relative safety of government debt.

Earlier in Asia, the Shanghai index shed 119.19 points, or 3.6% of its value, to close at 3170.98, its biggest one-day fall since August 31, while Hong Kong’s Hang Seng shed 1.8% to 22,210.41.

Wall Street was closed for the US Thanksgiving holiday.

Rattled investors fled from equities and snapped up gold and other precious metals, pushing up the price of bullion to a new record high of $1196.8 an ounce, before falling back as the dollar strengthened.

Credit Suisse analysts estimate European banks have about $40bn in exposure to debt issued by various Dubai city-state entities, including Dubai World.

Banks that acted as arrangers or bookrunners on Dubai World’s most-recent $5.5bn loan facility in June 2008 include British banks HSBC Holdings, Royal Bank of Scotland Group and Lloyds Banking Group, as well as Dutch-based ING Group.

French-based Credit Agricole’s Calyon investment arm, Bank of Tokyo-Mitsubishi, Sumitomo Mitsui Banking Corporation, Emirates Bank and Mashreq Bank were also involved in the transaction.

Royal Bank of Scotland said Dubai’s bombshell meant investors would now have to “re-appraise the quality of sovereign support for

state-owned entities in the region”.

Standard Chartered, another major lender in the region, said it does not comment on specific clients and would make a statement if it had anything material to disclose.

Lloyds Banking Group said its exposure to Dubai World is “modest” and does not pose a threat to the bank.

The other banks either would not comment or could not be reached. An Eid holiday means that government and private sector offices are closed throughout the Middle East until December 6.

Analysts expect financial support from deep-pocketed Abu Dhabi, a neighbouring member of the United Arab Emirates, to keep Dubai afloat. But Dubai will most probably have to abandon an economic model that focused on heavy real estate investment and inflows of foreign capital.

The announcement of trouble at Dubai World appeared to be timed to minimise its impact on regional markets; it came after the stock market shut and just before the eve of the long Eid holiday.

Dubai’s economy was hit hard as the global credit crunch over the past year ended a six-year boom in the region and sent the emirate’s once-flourishing property sector into decline.