The S&P/ASX All Ordinaries fell almost 2 per cent on Friday, or 126.9 points, to close at 6726.7, wiping out a week's worth of gains.
The sell-off in Australia was prompted by a 2.6 per cent slump on the Dow Jones Industrial Average last Thursday.
Nervous investors deserted the banking sector after analysts cut their ratings on US investment bank Citigroup citing credit concerns.
Macquarie Bank was one of the hardest hit in the financial services sector. The value of its stock fell almost 4 per cent to finish the day at $81.70
Shares in NAB fell 1.4 per cent to $42.91 and Australia New Zealand Bank stock fell 1.7 per cent to $29.90.
Resources giants were also hit by fears of consumer demand drying up in the United States.
Rio Tinto fell 3.5 per cent to $111 while BHP Billiton saw the value of its stock fall 4.3 per cent to $44.90 a share.
It was engineering firm Downer, however, that was the day's biggest casualty.
Its shares dropped 12.5 per cent to $5.81 after it cut its growth forecasts because of problems in its mining services division.
Colonial First State's head of investment markets research Hans Kunnen said he was unconcerned by Friday's fall.
"The markets only went down on Friday by as much as they went up the week before," he said. "There are short term risks but the medium term outlook is favourable."
The plunge in the Dow Jones came just a day after the US Federal Reserve Bank slashed interest rates by a further quarter point to 4.5 per cent.
The share market rally that followed was short-lived, and fears over yet more credit losses from the bulge bracket banks drove down markets.
Kunnen said the big US banks were likely to take further hits over the next 12 months and that it would be at least 18 months before the sub-prime shadow disappeared from the investment markets.
"Fundamentally things are fine. We just need to get over the twin humps of sub-prime and a slowdown in the United States.
The banks have made squillions over the last three years. None of them are going to starve."
Investors were also made nervous by news that the US economy is cooling.
The latest reports on manufacturing and consumer spending showed spending grew by 0.3 per cent, well below forecasts, and that US factory output fell in October to its lowest level in seven months.
"We will see more weakness in US housing to come, which will continue to put pressure on the markets over the next six months . . . these bouts of extreme nervousness are likely to continue for now," Kunnen said.
