The benchmark Nikkei average slid 5 per cent to a three-year low today, with investors dumping shares across the board after Lehman Brothers' collapse fuelled fears about the US financial system and hit stock markets worldwide.
Japan's top three lenders plunged, with Mizuho Financial Group and Sumitomo Mitsui Financial Group losing about 10 per cent.
Both the Nikkei and the broader Topix index, which dropped 5.1 per cent, booked their biggest percentage falls in eight months.
After a holiday yesterday, investors in Tokyo came back to work to find Lehman Brothers had filed for bankruptcy and Bank of America had agreed to buy Merrill Lynch in the biggest financial shake-up since the Great Depression.
"Investors are in shock for now as they had thought Lehman would be bought and rescued, but in fact it completely collapsed," said Mitsushige Akino, chief fund manager at Ichiyoshi Investment Management.
"But we can assume the US government sees some leeway in the situation, as it would have used public funds to help no matter what, had it decided that the failure of Lehman would completely batter the financial system."
With Merrill already securing help, the focus has shifted to the health of American International Group. AIG, once the world's biggest insurer, is also seriously constrained by short-term funding trouble.
The Nikkei average shed 605.04 points to end at 11,609.72, its lowest close since July 2005. The broader Topix lost 59.63 points to 1,117.57, its lowest finish since May 2005.
Exporters such as Canon and Toyota Motor Corp also tumbled after the yen gained sharply against the dollar, as investors ditched oil and sought stability in the yen and high-grade debt.
The dollar fell to 104.14 yen towards a four-month low of 103.77 yen.
"The difference from March when Bear Stearns collapsed is a slowdown in the global economy," said Masayoshi Okamoto, head of dealing at Jujiya Securities.
"The impact feels much bigger even though the Nikkei and the Topix are at the same level (as March)."
The Bank of Japan injected the money market with 1.5 trillion yen ($14.39 billion), its biggest cash infusion in six months, via a same-day operation today to help ease jitters following the collapse of Lehman. But some said they saw a buying opportunity at current levels.