UPDATE 1-Italian banks well capitalised but still face risks-IMF

* Recession, sovereign debt pose risk to Italian banks-IMF

* IMF recommends measures to shore up banks' defences

(Adds details, background)

MILAN, March 26 (Reuters) - Italy's banking sector is well capitalised but still faces risks because of a prolonged recession and exposure to sovereign debt, the International Monetary Fund (IMF) said on Tuesday.

In a report following a mission to Italy, the IMF recommended measures, including higher loan loss provisions and the development of a market for lenders to get rid of impaired assets, to further shore up the defences of Italian banks.

"Continuing weakness in the real economy and the link between the financial sector and the sovereign remain key risks," the IMF said in the report.

Italian banks were hit hard by the euro zone's debt crisis because of their large holdings of domestic government bonds.

As yields rose, lenders were forced by European regulators to mark-to-market their government bond portfolios and build capital buffers to offset losses. They have also have faced higher funding costs.

Most lenders managed to meet the new, tougher requirements, with the exception of Monte dei Paschi di Siena , which had to request a 4-billion euro state bailout last year.

After peaking at the end of 2011, sovereign yields have declined, but the IMF warned the debt crisis was not over.

It said stress tests it conducted on Italian lenders suggested they should be able to withstand "both a scenario of concentrated shocks and one of protracted slow growth."

But it warned that such scenarios would deplete the banks' capital cushions, pointing to a series of measures, such as higher provisions for bad debts, that would further strengthen the sector.

The Bank of Italy has already moved, forcing lenders to increase their loan loss charges in 2012 after conducting an industry-wide audit of problematic debts.

The IMF also said banking foundations - not-for-profit entities with close links to local politicians which hold stakes in Italy's top lenders - warranted closer oversight.

"The current legal framework should also be revised to require greater transparency, corporate governance and sound financial management."

It said the Bank of Italy should have stronger powers, including the authority to dismiss individual bank board members and managers.

The Italian central bank has been criticised over its oversight of Monte dei Paschi after it emerged that the lender's former management had carried out a series of risky derivatives trades to conceal losses.

It has rejected the criticism, saying it did everything within its powers to oversee the Tuscan bank, including forcing it to raise new capital and applying behind the scenes pressure to force out its executives, who left last year.

(Reporting By Silvia Aloisi; Editing by Louise Heavens)

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Keywords: ITALY BANKS/