* Italian BTP yields set for biggest 1-day fall since Dec
* Italy stocks rally, outpacing peers
* Electoral law deal unravels; risk of snap election recedes
* Banks to contribute to state bailout of two lenders (Updates with latest market moves, ECB decision)
By Dhara Ranasinghe and Danilo Masoni
LONDON/MILAN, June 8 (Reuters) - Italy' borrowing costs tumbled and its shares rallied on Thursday as the euro zone's third-biggest economy appeared to take a step towards resolving a crisis over two ailing lenders and a step back from snap elections.
Reports Italian banks are considering contributing to a state rescue of the country's weakest lenders, Popolare di Vicenza and Veneto Banca, brought some comfort to investors wary of wider banking sector weakness, political uncertainty and a tightening of monetary policy in the region.
Banking stocks in Italy rallied as much as 2.5 percent, reversing initial falls on worries that a subsequent intervention of the state in the troubled Veneto-based lenders could reduce the value of their investment.
Momentum in bond and stock markets took hold after a deal struck among Italy's main political parties over a new electoral law collapsed, easing concerns about early elections.
"BTPs rallied after the risk of a snap Italian election receded on news that Italy's big four political parties no longer agree on a new electoral law," said AFS analyst Arne Petimezas in Amsterdam.
"As a reminder, Italy needs a new electoral law before new elections can be held as the current law has been struck down by the constitutional court. A warning though: this is Italy and anything can happen."
The implications for early elections are far from clear. Analysts said a meeting of the ruling Democratic Party later on Thursday might bring more clarity.
Italy's 10-year government bond yield slid 12 basis points to 2.16 percent and was on track for its biggest one-day slide since December.
It outperformed other European bond yields, which were broadly lower after the European Central Bank cut its forecasts for inflation and said policymakers had not discussed scaling back its massive bond-buying programme.
Against this backdrop, the premium investors demand for holding Italian government bonds over top-rated German peers narrowed to 191 basis points - 12 bps tighter from seven-week highs hit on Wednesday.
"Some of the political risk premium is now coming out - investors were worried about the chance of a party less friendly to the euro zone coming into power," said Mizuho rates strategist Antoine Bouvet.
In a note, analysts at Goldman Sachs said they would assign around a 60 percent chance to an early ballot, with more clarity on timing by mid-July.
State support for the two Veneto-based banks is not expected to have a significant impact on Italy's debt - which at over 130 percent of GDP is one of the highest in the euro zone. Analysts estimate the two banks account for just 1.5 percentage points each of overall Italian banking assets.
Still, progress towards a rescue was viewed as positive, helping ease concern about a lack of progress in fixing a frail banking sector.
Rome won a preliminary green light from Brussels earlier this month over its a proposed rescue of its fourth-largest bank, Monte dei Paschi di Siena.
"I think it is positive as it reduces uncertainty and puts an end to this story," said Lorenzo Codogno, a visiting professor at the London School of Economics and chief economist at LC Macro Advisors.
"What is probably negative is that other banks have been asked to assist, which clearly does not bode well for the overall sector."
The euro zone bank index was up 1 percent, while Italy's two biggest lenders, Intesa Sanpaolo UniCredit , also rose, reversing earlier weakness but still lagging gains in the broader banking sector. They were up 0.7 percent and 1.6 percent respectively.
Italy's blue chip FTSE MIB index was up 1 percent while Italian banks were 1.3 percent higher. (Additional reporting by Stephen Jewkes in MILAN and Abhinav Ramnarayan in LONDON; Editing by John Geddie and Andrew Roche)