* European bank sees first earnings upgrades in 6 years
* Negative factors that have long weighed on sector ebbing
* German yield curve steepens: : reut.rs/2iY4VjL
* Banks & yields: reut.rs/2iXHcjP
* Europe vs U.S. bank profits: reut.rs/2a27exm
* European bank EPS revisions: reut.rs/2hZS2XS
By Dhara Ranasinghe and Vikram Subhedar
LONDON, Jan 6 (Reuters) - Improving economic conditions, a steeper government bond yield curve and an overall decline in bad debts suggest 2017 is shaping up as the healthiest year for Europe's banks in almost a decade.
The brighter outlook for the sector has in recent weeks prompted the first upgrades to analysts' earnings forecasts since 2010 while banking stocks, underperformers for three straight years, have raced to their highest levels since last January.
This marks a sharp contrast to a year ago when concerns about weak economic growth, the impact of negative interest rates on bank profits and higher regulatory costs provoked sharp falls in banking stocks across the region.
The steeper curve, which shows a rise in long-dated bond yields, is a boon for banks as they make money by borrowing short-term funds cheaply from central banks and lending them to clients at higher rates over the longer term. reut.rs/2iY4VjL
"Banks had faced a perfect storm, which was low growth, concerns around asset quality, low levels of trading volumes, regulation, negative interest rates and an ever flatter yield curve that was destroying their net-interest margin," said David Riley, head of credit strategy at BlueBay Asset Management in London. "Each of those has now dissipated."
Companies in Europe rely heavily on banks for financing; a study by the Centre for European Policy Studies, a think tank, estimates that 77 percent of their funding needs are met by bank lending. That compares with just 40 percent in the United States, where firms make greater use of corporate bonds.
On a relative basis, that makes the health of Europe's banks far more important for the region's companies and wider economy.
Profits at European banks have more than halved since 2008, while those at U.S. peers have recovered from the crisis that followed the collapse of Lehman Brothers and hit record highs last year. reut.rs/2a27exm
Now, better economic growth in Europe along with a healthier banking system would reverse trends that have plagued the region's prospects in recent years.
While risks remain, in particular high levels of bad debts at Italian banks and uncertainty around Britain's exit from the European Union, the backdrop for the banks as a whole has improved.
Net interest income, a key gauge of bank profitability, is likely to trough in the first half of the year for European banks, according to analysts at Morgan Stanley. They rate UBS of Switzerland, along with Spain's Bankia and CaixaBank as among their top stock picks in the sector.
"Three Rs - Reflation, Restructuring and Regulations - will make 2017 a pivotal year," the analysts said in a note to clients.
Steepening government bond yield curves across the globe as investors bet on higher inflation, economic growth and greater state spending are also turning into a tailwind for banks.
The curve steepens when the gap between long-and short-dated yields widens, often reflecting a broadly healthy economy and financial system.
The gap between two-year and 10-year yields in Germany, the euro zone's benchmark issuer, is at 96 basis points - almost double where it was six months ago.
That spread shares a close relationship with banking stocks in the euro area. reut.rs/2iXHcjP
Typically, investors demand higher yields for lending to governments for longer periods to compensate for the greater inflation and credit risks.
While banks benefit from a rise in long-term yields, the curves, especially between two- and 10-year debt, have until recently been the flattest in many years. This was due to central banks' policies of stimulating economies through buying bonds and a perception that growth and inflation would stay low for years.
A recognition by central banks that negative interest rates are harmful to the banking sector and outweigh the benefits of lower rates has underpinned investors' optimism, analysts say.
The European Central Bank said last month that bonds with maturities of between 1 and 2 years will be included in its purchases and that it would buy debt yielding less than its -0.4 percent deposit rate, if necessary. Those measures, targeting buying at the short-end of the yield, had an immediate steepening impact on the yield curve.
That followed a more explicit change in policy by the Bank of Japan in September to target government bond yields.
Nicolas Forest, global head of fixed income at Candriam Investors Group, sees the hand of ECB President Mario Draghi.
"At the end of the day it is very clear that Draghi wanted to steepen the yield curve to help the banking sector," Forest said. "He knows that a negative deposit rate has distortions in the markets and negative rates are like a taxation for the banks, so to balance that they decided to remove the yield floor."
Additional reporting by Andrew MacAskill; editing by David Stamp