LONDON - European stocks shed 3 percent on Monday and the euro sank against the dollar as markets weighed a risk-heavy outlook for the euro zone, dominated by peripheral debt concerns and political uncertainty in Germany.

Worries about public deficits in Greece and Italy and a regional election rout for Germany's ruling party cast fresh doubt on the euro zone's ability to tackle its debt crisis, extending Friday's selloff.

Wall Street was closed for a holiday but is was unlikely that U.S. investors would have been in a more positive mood given data ahead of the long weekend that showed U.S. employment growth halted in August.

That fueled concerns that the world's biggest economy is slipping back into a recession.

The euro zone, meanwhile, faces a week packed with political and legal risks, beginning with a German constitutional court ruling on Wednesday on claims that Berlin is breaking German law and European treaties by contributing to bailouts for Greece, Ireland and Portugal.

The court is not expected to rule against the contributions, but may add stipulations for dealing with future requests that will complicate the region's bailout plans.

The yield premiums investors demand to hold Italian and Spanish 10-year government bonds rather than benchmark German Bunds hit their highest levels in a month.

Not a great start to the week. There is a lot going on for banks, especially in the light of a low-growth environment and the backdrop in the euro zone not improving, said Mike Lenhoff, chief strategist at Brewin Dolphin.

The MSCI all country world equity index was down 1.8 percent on the day.

European stocks fell 3.3 percent, with the banking sector hitting a 29-month low.

There is massive tailrisk in the system right now, said Andrew Lim, banks equity analyst at Espirito Santo.

BATTERED EURO

The dollar rose half a percent to a one-month high against a basket of major currencies.

The euro fell across the board, hitting a three-week low of $1.4111 and dipping 1 percent against the safe-haven Swiss franc.

As many European financial institutions are saddled with losses on bond holdings, traders are also worried that their funding could face more strains, putting pressure on the single currency.

As pressure mounted on Italy -- the euro zone's third-largest economy -- to get its fiscal house in order, Italian 10-year yields rose to 5.487 percent, their highest since August 9.

Recent buying by the European Central Bank had pushed them down to the 5 percent level.

Besides the German court ruling, a meeting of finance ministers of Germany, the Netherlands and Finland will be closely eyed as they discuss the nagging issue of collateral for loans to Greece.

Debate over the effectiveness of ECB bond-buying is likely intensify at the bank's monthly policy meeting on Thursday.

We will probably get the ... assertion that 'all euro zone countries must stick to their fiscal plans as agreed with the euro zone authorities', Richard McGuire, rate strategist at Rabobank, said.

Singling out Italy -- there is a risk that that would be counterproductive because it would put Italian yields under significant pressure and therefore undo much of the work that the ECB has done.

(Additional reporting by Simon Jessop and Ana Nicolaci da Costa; Editing by John Stonestreet)

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