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UPDATE 3-Italian markets jolted by 5-Star, League coalition proposals

* 5-Star/League draft document rattle markets

* League dismisses debt forgiveness talk

* Italy's FTSE MIB, bank stocks sink https://reut.rs/2rKCYBQ (Updates with latest price developments)

LONDON/MILAN, May 16 (Reuters) - Italy's borrowing costs jumped on Wednesday and its stocks slid after a draft programme for a potential coalition government revealed plans to demand 250 billion euros of debt forgiveness and create procedures to allow countries to exit the euro.

The anti-establishment 5-Star Movement and the far-right League party plan to ask the European Central Bank to forgive the debt, according to a draft the parties are working on, the Huffington Post Italia website reported late Tuesday.

Another proposal causing alarm in financial markets is the creation of "economic and judicial procedures that allow member states to leave monetary union".

The report spooked markets, even though the League's economic spokesman told Reuters that debt cancellation was never in an official draft of a government programme.

Italian bonds and equities stood out as the laggards of European markets, and even the euro succumbed to selling pressure after trading steady for much of the morning session.

"It's right to resonate with markets because it tells you about the sense of the wisdom between these negotiating parties," said Chris Scicluna, head of economic research at Daiwa Capital Markets.

"With continued ECB bond-buying there is confidence there won't be a disorderly selloff, but if you get fiscally irresponsible policies and confrontation with the ECB and EU partners then there's a risk of a far greater blow-out of Italian bond spreads."

Italy's 10-year bond yield jumped 14 basis points to 2.08 percent, its highest level since early March. This is the biggest one-day rise since July 2017, Reuters data shows.

The gap over benchmark German Bund yields widened to 148 bps, its widest since the day after Italy's March 4 election.

This spread, a closely watched indicator of relative risk, was 129 bps on Tuesday.

The news also pushed Italy's debt insurance costs in the five-year credit default swaps (CDS) market to 102 basis points, the highest since end-March, according to IHS Markit.

Italian two-year bond yields meanwhile jumped almost 20 bps to 0.116 percent, trading above zero percent for the first time since May 2017, according to Reuters data.

League leader Matteo Salvini said on Wednesday said he was not intimidated by a rise in bond yields.

But unease was evident across Italian markets.

Italian stocks fell 2.5 percent, set for their biggest one-day drop since the country's inconclusive general election in March. It was on track for its worst day since Jan 2017. The pan-European STOXX 600 was flat.

Shares in Italian banks, considered a proxy for political risk in the country due to their large holdings of government bonds, were broadly lower, with a sectoral index on course for their worst day in five months, down 2.9 percent.

Shares in the country's two biggest lenders UniCredit and Intesa Sanpaolo declined around 3 percent.

The euro fell 0.5 percent to $1.17765 after sliding below $1.18 for the first time since late December.

The 39-page document leaked on Tuesday also called for a renegotiation of Italy's European Union budget contributions.

It is likely to cause concern in Brussels and at ECB headquarters in Frankfurt and might also dismay Italian President Sergio Mattarella, who has stressed the importance of the country maintaining a strong, pro-European stance.

"Even if unfeasible, the tone of the debate bolsters expectations there will be a stormy relationship with Europe and a further relaxation of financial discipline," said Giuseppe Sersale, fund manger at Milan-based Anthilia Capital Partners.

5-Star and the League favour big-spending policies that include promises of tax cuts, increased welfare handouts and a roll back of an unpopular pension reform.

Some analysts, however, see the headlines as mostly noise and reckon the proposals will likely be moderated by Mattarella.

"This is very early days and most people believe a watered-down version will materialize finally, which also would be some concern to investors," said Ioannis Sokos, a European rates strategist at Nomura in London.

Indeed, Italian markets have so far proved resilient to signs of a 5-Star/League government - the worst case scenario for markets - taking shape.

Italy's 10-year government bond yield is 20 bps below levels traded a year ago and 190 bps lower than where they were 5 years ago.

(Reporting by Dhara Ranasinghe, Tom Finn, Helen Reid and Saikat Chatterjee in London and Danilo Masoni in MILAN; Editing by Jon Boyle and Raissa Kasolowsky)