* Banking index set for biggest drop in more than a year
* Banks vulnerable to higher Italian yields
By Valentina Za
MILAN, March 5 (Reuters) - Investors dumped Italian bonds and banking stocks on Monday after a national election delivered a hung parliament and turned the anti-establishment 5-Star Movement into the country’s largest single party.
The possibility of power passing to a more eurosceptic coalition, which would be likely to push for higher welfare spending and challenge European Union budget restrictions, fuelled concerns over Italy’s 2.3 trillion euro public debt, one of the world’s highest.
By 0853 GMT, Italy’s banking stock index fell 3.4 percent, on track for its biggest one-day loss in more than a year and underperforming a 1.4 percent drop in Italy’s main stock index.
Benchmark 10-year bond yields rose to 2.14 percent in early trade, their highest level since October, before easing back to 2.09 percent by 0950 GMT.
Projections gave the biggest bloc of votes to a rightist alliance including ex-Prime Minister Silvio Berlusconi’s Forza Italia (FI) party. But the biggest single party by far is the anti-system 5-Star Movement - an outcome that offers little prospect of a return to mainstream government.
“Italy is far from having sorted its long-standing problems, and now it will have new ones,” Lorenzo Codogno, founder of LC Macro Advisors, said. “Be prepared for long and complex negotiations that will take months.”
Concerns that any coalition emerging from negotiations could be likely to weaken Italy’s fiscal stance are impinging on the country’s banks, which hold around 345 billion euros ($425 billion) of its debt and are considered a proxy for sovereign risk.
Italy’s banking index recently hit a near two-year high after state rescues last year removed the threat of a systemic crisis and lenders started offloading debts that turned sour during a deep recession that ended in 2014.
Leading losses with a 7 percent plunge on Monday was Banco BPM, Italy’s third-largest bank. Its business is domestically focused and it is burdened by a large pile of impaired loans.
Shares in UBI Banca <UBI.MI and BPER Banca, respectively the country’s fifth- and sixth-largest lenders, were 5 percent lower while heavyweights Intesa Sanpaolo and UniCredit lost just over 3 percent.
The 5-Star movement has pledged to compensate further small savers left out of pocket by a string of banking crises, and wants to split lenders’ commercial and investment banking businesses.
“Although the season of bank bailouts is virtually over, Italy should not let its guard down,” Lazard’s Managing Director Massimo Pappone said. “Key issues are at stake: bank lending ... and the handling of so-called unlikely-to-pay loans (to borrowers in difficulty but not yet in default), which can be a lever to support the economy.”
Investors fear Rome may now row back on market-friendly reforms pushed through by the former centre-left government, hurting economic expansion.
“The prospect of a prolonged period of domestic political uncertainty risks weighing on the ongoing recovery,” said Nicola Nobile of Oxford Economics.
Italy needs to grow to sustain a public debt equivalent to more than 1.3 times the country’s output, a ratio surpassed only by Greece in the euro area.
Rome’s debt costs, which risked spiralling out of control during the sovereign debt crisis of 2011-2012, are set to rise as the European Central Bank starts unwinding its ultra-expansionary policies.
The yield premium Italian bonds pay over safer German peers rose to 1.54 percentage points, the highest since January. Bunds strengthened after Germany’s Social Democrats on Sunday backed another coalition with Chancellor Angela Merkel’s conservatives, clearing the way for a new government in the euro zone’s largest economy.
Another notable Italian loser, with shares dropping 5 percent, was broadcaster Mediaset, which is controlled by the Berlusconi family and is mired in a legal spat with French media group Vivendi over a derailed pay-TV deal.
Berlusconi’s party’s poor results in the election are seen weakening Mediaset’s bargaining power in the row.
$1 = 0.8118 euros Additional reporting by Danilo Masoni, Giulio Piovaccari and Andrea Mandala, editing by John Stonestreet