Stocks dropped on Monday as bank shares bore the brunt of investor frustration over governments' inability to solve debt crises in the United States and Europe.

With five days to go before President Barack Obama's deadline for a debt ceiling deal and no agreement in sight, Republicans and Democrats were crafting a fallback plan to avert a U.S. default.

The longer the debt ceiling debate remains unresolved, the bigger the risk for further declines in stocks and a spike in volatility. The CBOE Volatility index <.VIX> rose 7.8 percent on Monday after a gain of more than 20 percent last week.

Adding to pressure on financials, the euro zone's regulatory stress tests for banks were viewed as unrealistically soft, given the scope of the crisis.

It's not a good environment for financials, said Terry Morris, senior equity manager for National Penn Investors Trust Company in Reading, Pennsylvania.

The market is really scared right now and it's a fragile economy that we have, so when you throw something like this in the cake, then you have investors sitting on the sidelines or selling.

Bank of America Corp hit a new 52-week low and ended down 2.8 percent to $9.72 while Citigroup Inc lost 1.7 percent to $37.74. Financials were the weakest S&P sector on Monday, losing 1.4 percent.

The Dow Jones industrial average <.DJI> dropped 94.57 points, or 0.76 percent, to 12,385.16. The Standard & Poor's 500 Index <.SPX> declined 10.70 points, or 0.81 percent, to 1,305.44. The Nasdaq Composite Index <.IXIC> fell 24.69 points, or 0.89 percent, to 2,765.11.

Expectations of strong earnings could fuel optimism, but it may not be enough to lift the market from its recent decline. Last week's encouraging results from Google Inc and JPMorgan Chase & Co were overshadowed by global economic worries that sparked the S&P 500's worst performance in five weeks.

In the latest earnings news, Halliburton Co reported a 54 percent jump in quarterly profit as a U.S. onshore drilling boom showed no sign of cooling off. The stock edged up 4 cents to $53.12.

Second-quarter earnings for S&P 500 companies are seen rising 6.5 percent, and of the 44 companies in the S&P reporting so far, 75 percent posted higher-than-expected profits, according to Thomson Reuters Proprietary Research.

After the closing bell, International Business Machines Corp said quarterly profit rose 8 percent from a year earlier, buoyed by strong growth in sales of its computers and software. Shares gained 2.4 percent to $179.45 in extended trading.

Allstate Corp shares fell 5 percent to $28.01 after a senior executive left the largest publicly traded U.S. home and auto insurer, and analysts said the pressure was on management to produce results. The KBW insurance index shed 2.8 percent.

Volume was light with about 6.89 billion shares traded on the New York Stock Exchange, NYSE Amex and Nasdaq, below the daily average of 7.49 billion.

Declining stocks outnumbered advancing ones on the NYSE by 2,569 to 446, while on the Nasdaq decliners beat advancers 2,027 to 543.

(Reporting by Chuck Mikolajczak; Editing by Kenneth Barry)

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