* Italy sells bonds at top of planned range
* Bond sale last Italian auction of 2016
* Italian yields hold near 2-week lows
* German Bund yields hit new 7-week low (Updates prices)
By Dhara Ranasinghe
LONDON, Dec 29 (Reuters) - Italian government bond yields held near two-week lows on Thursday after demand proved to be resilient at the final auction of 2016 despite a banking crisis.
Italy sold 6.75 billion euros of debt in four separate bonds (BTPs), at the top of its planned range for the issues.
Borrowing costs had risen sharply at the last auction in late November as investors fretted about looming political instability in the wake of a Dec. 4 referendum. Prime Minister Matteo Renzi resigned after his reform proposals were rejected.
"The amount issued today was relatively low, so it was easily sold," BBVA strategist Jaime Costero Denche said. "They usually sell about 8 billion euros of BTPs."
Italy's benchmark 10-year bond yield was down 4 basis points at 1.80 percent by 1615 GMT, holding near a two-week low hit ahead of the auction.
The sale took place against a backdrop of intense focus on Italy's banking sector and the future of troubled lender Monte dei Paschi, which has requested aid from a new 20-billion-euro state fund to help lenders in distress.
Efforts to clean up the banks and a smooth transition to a new prime minister, Paolo Gentiloni, have helped Italian bonds recover from losses made in the run-up up to the referendum.
Still, there are concerns about the strength of the bailout fund. This week, the European Central Bank told Monte dei Paschi its capital shortfall had risen to 8.8 billion euros from the 5 billion indicated previously, raising questions about whether those funds would be enough to cover the sector's needs.
In a note, DZ Bank analyst Daniel Lenz highlighted the implications of state subsidies for banks on Italy's fiscal position and in turn on its ratings outlook.
"The effects of the subsidies on the state finances are not without an explosive aspect," he said.
The link between Italy's banks and the bond market is a major concern for investors. Banks, which hold large amounts of government debt, have been hit by worries over their exposure to bad loans built up during years of economic downturn.
Italy's Treasury said last week that it sees tougher conditions for debt issuance in the year ahead.
Still, BBVA's Costero Denche said he saw some supportive factors for Italian bond sales next year.
"We are going to get QE (quantitative easing) continuing, so that support will still be there. Second, the hunt for yield will possibly continue and if that happens the periphery as a whole should benefit," he said.
Elsewhere, euro zone bond yields were broadly lower. Germany's 10-year Bund yield fell to a new seven-week low of 0.17 percent as investors continued to unwind some of the recent sharp rises into year-end. (Editing by Louise Ireland)