* Pan-European STOXX edges up 0.2 pct
* Italy's FTSE MIB down, led by banks
* Upgrade boosts oil services firm Saipem (Adds quotes, closing prices)
MILAN/LONDON, May 16 (Reuters) - Italy's two anti-system parties' progress to form a coalition and free up billions of euros for tax cuts and welfare scared off investors and hit the Milan bourse on Wednesday while a weak euro provided support to the broader European market.
The pan-European STOXX 600 index rose 0.2 percent, hovering around its highest level since early February but Italy's FTSE MIB fell 2.3 percent, its worst fall since the election took place in early March.
Italian banks, which are seen as a proxy for political risk in the country due to notably to their government bond holdings, fell 3.68 percent as borrowing costs jumped.
Italy already has a debt pile worth more than 130 percent of annual output and the parties' pledge to introduce a flat tax rate of 15 percent, new welfare payments and scrap an unpopular pension reform are likely to street the country's finances.
The fall of the Milan bourse comes after months of outperformance against its European peers despite the fact that the far-right League and the anti-establishment 5-Star Movement emerged as clear winners from the election.
"I often think that political risk is over-priced into the market, but this time it hadn't really been priced in at all," said Chris Hiorns, manager of the Amity European fund at EdenTree.
"You have to question why the Italian market was doing quite so well when the political situation seemed so tenuous," said Hiorns, adding that Italian stocks might suffer further and government bond yields rise even more.
One exception on the Italian market was Saipem, which soared 12.2 percent to the top of the STOXX after it was upgraded by Bernstein to "outperform", reflecting growing optimism in the recovery of the embattled Italian oil services firm.
The recent surge in crude oil prices has helped the oil and gas sector rise 13 percent so far this year, leading sectoral gainers in Europe.
A weaker euro provided support for dollar-earning European companies as the dollar extended its rally against a basket of currencies on Wednesday and touch a five-month high.
Miners and the broader basic materials sector benefited from the trend and closed 2.79 percent higher.
Among the other top gainers on the STOXX was Homeserve which surged to 9.3 percent after UBS upped its recommendation for the stock to "buy".
Micro Focus, which rose 6.1 percent after Britain's leading software company said a new $40 million licensing deal would help bolster its first-half revenue.
Paddy Power Betfair rose 6.7 percent after the bookmaker said it was in discussions regarding a potential combination of its U.S. business and fantasy sports company Fanduel to target the prospective U.S. sports betting market.
Elsewhere, Elior, however, fell 13.9 percent following a profit warning. (Reporting by Danilo Masoni, Helen Reid and Julien Ponthus; Editing by Catherine Evans and Alison Williams)