Fitch warns on Italian banks; ECB funding rises

MILAN (Reuters) - Italian banks risk being caught in a vicious cycle and face a further loss of confidence if the euro zone debt crisis worsens, Fitch warned on Friday, as data showed Italian lenders increasing their reliance on the European Central Bank for funding.

Explaining its decision to downgrade Italy's sovereign debt rating to A+ from AA-, Fitch said the increased cost of funding and worsening asset quality due to the weak economy would place further pressure on the banks' already strained profitability.

"Of greater concern to Fitch is the small but no longer negligible tail risk that a further worsening of the euro zone debt crisis and volatility in the value of Italian government bonds will further erode confidence in the banking system," Fitch said.

"In such a scenario, concerns about the banks would start to weigh on the sovereign credit profile as a contingent liability, and a vicious cycle of deteriorating sovereign and bank credit quality could emerge."

Italian banks, which are big holders of domestic government bonds, have been hit hard in a market sell-off sparked by concerns that the euro zone's third-largest economy is being sucked into a spreading debt crisis.

Shares of banking heavyweights UniCredit and Intesa Sanpaolo have been battered as investment funds used them as proxy to sell Italian debt.

In turn, rising Italian bond yields have increased funding costs for banks, effectively shutting them out of the wholesale debt market.

With interbank lending across Europe crippled by growing caution among banks, calls are mounting for European governments to shore up ailing lenders.

Data posted on the Bank of Italy's website on Friday showed funding from the ECB rose to 104.7 billion euros (90.13 billion pounds) at the end of September from 85 billion euros a month earlier.

Reliance on ECB funding for Italian lenders has risen sharply since the end of June, when it stood at 41.3 billion euros.

"The banks are suffering given the interbank market is under pressure, though it's not just Italian banks," said Paolo Mameli, an economist at Intesa Sanpaolo.

"Italian banks have been borrowing more (from the ECB) because of the sovereign debt crisis," he said.

Fitch said Italian banks need to further raise their capital ratios to bring them into line with international peers and Basel III regulations, as well as shore up confidence in wholesale markets.

Italian banks have already carried out capital increases worth 11 billion euros this year, with the notable exception of UniCredit, which is expected to announce capital-boosting measures when it unveils its new business plan in November.

JPMorgan estimated this week that UniCredit faced a deficit of more than 7 billion euros under a stress scenario. (Reporting by Silvia Aloisi; additional reporting by Stephen Jewkes; editing by John Wallace)