TOKYO (Reuters) - A global selloff in bank shares turned ominous with a collapse in Japanese bank stocks on Friday to their worst weekly loss in at least 40 years while U.S. and European lenders continued to decline, as fear of a global recession swept markets.

Banks, as barometers of growth, have been hammered worldwide as the U.S. breaks with the free trade order that it built up over decades and President Donald Trump puts up the highest tariff walls in a century.

This week's falls of 20% or more in shares of Japan's three megabanks are the biggest since the financial crisis of 2008 - and in some cases bigger - in one of the markets' most unsettling signals so far about the consequences of Trump's trade war.

Shares in European lenders extended losses, too. A basket of the region's banks had dropped 6.5% in early trade to its lowest since early February, after falling 5.5% on Thursday.

That followed massive drops in U.S. banks overnight, when Citigroup ( C/PN ) fell more than 12% and Bank of America ( BAC ) sank 11%. Morgan Stanley ( MS ), Goldman Sachs ( GS ) and Wells Fargo ( WFC ) fell more than 9% each.

"The world has changed, and in few economies do these changes reverberate as strongly as in Japan," said Fred Neumann, chief Asia economist at HSBC in Hong Kong.

Flight to the safety of bonds lifted 10-year Japanese government bond futures almost to the threshold for a trading halt, while yields, which fall when prices rise, were set for a drop of 35 basis points on the week - the largest fall since 1993. [JP/]

Investors, who had been expecting at least one interest rate increase by the Bank of Japan this year, all but removed any chance of a hike at all, triggering a spectacular unwinding of the market's crowded bet on higher rates and bigger lending margins.

With a recent decline in U.S. 10-year yields and a paring of rate-cut expectations, the market is worried that it will be harder for Japan to raise rates now, said Sean Taylor, chief investment officer at Matthews Asia.

"So Japanese banks are factoring in no rate hike."

Shares in Japan's biggest bank by market value, Mitsubishi UFJ Financial Group ( MUFG ), fell 8.5% on Friday for a weekly loss of 20% - the largest since 2003.

Mizuho Financial Group ( MFG ) fell 11% on Friday and more than 22% for the week, the largest drop since 2008, while shares in Sumitomo Mitsui Financial Group ( SMFG ) slid 8% on the day and more than 20% for the week. The three banks' combined loss in market value this week exceeded 10 trillion yen ($69 billion).

"It's a wholesale move out of banking stocks and I think this will continue," said Amir Anvarzadeh, Japan equity strategist at Asymmetric Investors.

U.S. banking shares had also been riding high as recently as a few weeks ago on projections of a bright outlook for 2025, based on expectations of M&A deregulation and lower corporate taxes.

Japan's TOPIX banks index, which touched a 19-year high only two weeks ago, is down 24% from that high. Its weekly drop of 20.2% is the biggest in LSEG data stretching back to 1983.

The benchmark Nikkei share average ended Friday 2.75% lower, with insurers, chip makers and shipping lines also among the heaviest losers. The average's decline for the week, at 9%, was the worst since the pandemic-driven meltdown of March 2020.

Benchmark 10-year Japanese government yields had tumbled nearly 20 basis points by the afternoon, for a drop of more than 38 bps on the week so far, the largest fall since 1990.

"It is quite incredible," said Ales Koutny, head of international rates at Vanguard. "We are putting this down to hedge funds running for the exits."

($1 = 146.0500 yen)