UPDATE 2-Italian banks cut lending to business further

* Loans to non-financial firms down 1.9 pct in August

* Bad debts up; government bond holdings steady

(Adds Banco Popolare pulling bond)

By Silvia Aloisi

MILAN, Oct 8 (Reuters) - Italian banks are parking theirmoney in domestic government bonds rather than lending it tobusinesses, central bank data showed on Monday, signalling aworsening credit crunch in the euro zone's third largesteconomy.

Lending to non-financial companies fell by 1.9 percent inAugust from a year earlier, the fourth consecutive monthlydecline and the worst fall since the data turned negative inMay.

Overall loans to the private sector, which includesfinancial companies, were also down, by 0.2 percent, the firstcontraction since February 2010, the data from the Bank of Italyshowed.

At the same time Italian banks kept their government bondholdings roughly steady at 316.4 billion euros ($413.2billion)in August - one billion euros less than in July. InAugust 2011, the total stood at 212 billion euros.

The lenders have benefited from a glut of cheap EuropeanCentral Bank funds and higher customer deposits, but risinglevels of bad debts have made them increasingly reluctant toextend credit to the private sector.

Instead, some of the ECB funds - borrowed by Italian andother euro zone banks over three years at ultra-low interestrates in tenders held in December and February - have been usedto help cover Rome's financing needs.

There has been a similar pattern in other countries onEurope's periphery.

Tensions on debt markets have eased over the past monthafter the ECB pledged to conditionally buy bonds of troubledeuro zone countries. The yield on Italy's 10-year bonds stood at5.08 percent on Monday compared to 5.85 percent in earlySeptember.

That has prompted some of Italy's biggest banks - includingIntesa Sanpaolo , UniCredit and Mediobanca

- to tap wholesale funding markets, which had largelyshut them out at the peak of the euro zone debt crisis.

But in a sign that some lenders are struggling to lureinvestors, Banco Popolare pulled a 3.5 years seniorbond on Monday - its first attempt to fund itself on the marketsince March 2011 - because there was not enough demand.

Tougher pan-European regulations have forced banks tostrengthen their capital base to better guard against economicshocks, and this too has made them more selective in lending -particularly as existing loans are increasingly turning sour.

The Bank of Italy data said bad loans had posted annualgrowth of 15.6 percent in August from 15.4 percent a monthearlier.

With Italy's economy forecast to be in recession this yearand next, credit quality deterioration is becoming a top concernfor investors. In a recent report, Morgan Stanley analysts saidbad debts at Italian lenders would probably approach 10 percentof the loan book at the end of 2013.

On a brighter note, Italian savers are not pulling theirmoney out of the country, as has happened in Greece and, to someextent, in Spain.

Private sector deposits at Italian banks rose 3.5 percent inAugust, the first time since February 2010 they have grown bymore than 3 percent.($1 = 0.7657 euros)

(Reporting by Silvia Aloisi; Editing by Anthony Barker)

((silvia.aloisi@thomsonreuters.com)(+39 02 6612 9723))

Keywords: ITALY BANKS/