* Italy-Germany bond yield spread comes off recent narrow levels
* Deal to add up to 17 billion euros to outstanding state debt
* Greece's 10-year borrowing costs lowest since 2009 after upgrade
* Euro zone periphery govt bond yields http://tmsnrt.rs/2ii2Bqr (Writes through)
LONDON, June 26 (Reuters) - Euro zone government bond yields fell after Italy received the go-ahead for a state rescue of the assets of two failed lenders, helping to shore up its ailing banking system which is seen as dragging on growth in Italy and the bloc as a whole.
The European Commission ended months of speculation over whether Italy would be able to bypass regulations preventing state bailouts of banks by granting approval for the deal.
On Sunday, Italy began winding up two failed regional banks in a deal that could cost the state up to 17 billion euros ($19 billion). The rescue will see the lenders' good assets go to Italy's biggest retail bank, Intesa Sanpaolo.
The Italian banking system is choked by a high level of bad loans and the prospect of some relief was enough for investors to buy up Italian bonds despite the additional borrowing such a rescue entails.
"Negative consequences for the Italian state will be offset by the positive consequences for Italian government bonds in terms of reducing the already high uncertainty surrounding this issue," said BBVA strategist Jaime Costero Denche.
Indeed, after an initial spike in early trade, Italian government bonds were among the best performers on the day by noon.
The yield on 10-year Italian debt dropped 3 basis points to 1.88 percent, while most other euro zone government bond yields were lower 1-2 bps.
"There is the danger that other banks need state support, but I think there's more clarity now that there is a solution for the banking sector," said ING strategist Martin van Vliet.
Italy's bond yield spread over Germany see-sawed from 168 bps in early trade to 164 bps by midday.
BBVA strategists believe that if the entire 17 billion euros is used, it would add about 1 percentage point to the country's debt as a percentage of its economic output. Italy's debt-to-GDP ratio is among the highest in the world at 132.6 percent at the end of 2016, according to EU data.
Italy was also in the news on the political front, its center-right parties proving the big winners in mayoral elections on Sunday, partial results showed.
The vote is likely to put pressure on the center-left government ahead of national elections due in less than a year.
Also on Monday, Greece's 10-year borrowing costs dropped to their lowest since 2009 after Moody's upgraded its credit rating on Friday, with yields approaching levels at which Athens might consider returning to the bond market.
Later on Monday, European Central Bank chief Mario Draghi is due to speak, at a time when investors are looking for clues on when the bank will end its ultra-loose monetary policy stance.
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(Editing by Ed Osmond and Raissa Kasolowsky)