* Gap between Spain-Italy yields hits 50 bps
* Bank bailouts and politics put investors off Italy
* Italy approves 20 bn borrowing for banks
* Spanish lenders face 4 bln euro bill after court ruling (Recasts, adds detail)
By Nigel Stephenson and John Geddie
LONDON, Dec 21 (Reuters) - Spanish government bond yields hit five-week lows on Wednesday as the sometimes toxic link between sovereign debt and the banking sector in the lower-rated countries of the euro zone weighed on debt markets.
Concern over whether troubled Italian lender Monte dei Paschi would be able to raise the 5 billion euros ($5.2 billion)it needs to avert being wound down initially saw investors pull money out of Italian government bonds and into similarly-rated Spanish debt.
The gap between yields on Spanish and Italian 10-year debt nudged back above 50 basis points (bps), a level last breached in the days after a failed constitutional reform vote triggered the resignation of Italian Prime Minister Matteo Renzi.
Italy's parliament later approved a government request to borrow up to 20 billion euros to underwrite its fragile banks, easing investors' immediate worries.
Strategists at ING said the combination of possible snap elections next year and higher bond issuance to prop up Italy's ailing banks "arguably make for a dangerous cocktail" for Italian bonds in 2017.
However, Spanish banks also took a hit on Wednesday from a European Court of Justice ruling that will require them to repay mortgage customers more than 4 billion euros.
By 1630 GMT, Spanish 10-year yields stood at 1.36 percent, up 2.5 basis points on the day, having fallen as far as 1.31 percent, their lowest since Nov. 10, earlier in the day.
"The only fundamental I can see behind this is the news about the banks," Mizuho strategist Peter Chatwell said.
Italian 10-year yields fell 1.6 bps to 1.83 percent, narrowing the spread between the two to 47 bps.
Another key event for Italy's banks will come on Jan. 13, when ratings agency DBRS will decide whether to downgrade the country in a move that could increase costs for its lenders.
DBRS's co-head of sovereign ratings and chief economist Fergus McCormick told Reuters the next 24 hours, how the problems at Monte dei Paschi were addressed and whether a plan was drawn up to shore up the banks would be crucial for the rating.
A downgrade would mean banks would have to stump up more collateral for European Central Bank funding.
Shares in Monte dei Paschi closed down 12 percent after falling as much as 19 percent in very volatile trade.
Two sources close to the matter said the bank had been unable to find an anchor investor willing to put money in its privately funded rescue plan.
The worst performing share on the pan-European STOXX 600 index, of which Monte dei Paschi is not a constituent, was Spain's Banco Popular.
Ten-year yields on bonds of the higher-rated euro zone members fell 1-2 bps on the day. German Bund yields, the benchmark for borrowing costs in the bloc, fell 1.9 bps to 0.25 percent.
For Reuters new Live Markets blog on European and UK stock markets see reuters://realtime/verb=Open/url=http://emea1.apps.cp.extranet.thomsonreuters.biz/cms/?pageId=livemarkets ($1 = 0.9590 euros) (Editing by Alexandra Hudson)