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UPDATE 3-Turkish state banks sell dollars to support lira - sources

Orhan Coskun

* Decision to re-run Istanbul poll has harmed lira

* State banks sell dollars to help support lira - sources

* Analysts say central bank may need to hike policy rate (Updates prices, adds context)

ANKARA, May 10 (Reuters) - Turkish state banks sold more than $1 billion on Thursday and overnight, sources said, helping the lira to firm more than 2% at one stage and stem declines triggered by a decision this week to re-run Istanbul's mayoral election.

The lira traded at 6.0975 at 1315 GMT, up from Thursday's close of 6.1935. The currency rose to 6.0515 against the U.S. dollar in overnight Asia trade.

Ziraat Bank, Turkey's largest lender by asset size, was one of the banks that sold dollars to support the lira, according to two sources familiar with the matter. Ziraat Bank was not immediately available for comment.

The sources did not specify which funds the banks used for the dollar sales, but economists say the banks have used dollars sourced from Central Bank facilities earlier this year to sell into the market to support the lira.

The lira has lost as much as 15 percent against the dollar this year, with the latest weakness driven by investor concerns over Monday's decision to re-run a mayoral election in Istanbul that had been narrowly won by the main opposition party.

Electoral authorities canceled the result of the March 31 vote in Turkey's largest city and commercial hub after weeks of appeals from President Tayyip Erdogan's defeated AK Party.

On Thursday Turkey's central bank effectively tightened policy by funding the market through a higher rate and took additional liquidity steps to bolster the lira.

INFLATION WORRIES

The move to suspend one-week repo auctions for the second time in less than two months will gradually raise the average cost of funding from the bank's benchmark one-week repo rate of 24 percent to the overnight lending rate of 25.5 percent.

Some analysts have said a more effective measure to stem the lira's fall would be a straightforward hike in the policy rate.

"The steady trend of (lira) depreciation could potentially push inflation significantly higher than expected even beyond 2019. The central bank move has had markedly limited positive impact on the currency this time around," Yatirim Finansman said in a note to clients.

"If CBRT wants to stop (lira) volatility effectively, it might have to introduce a plain vanilla monetary tightening."

The bank also said it lowered a foreign exchange maintenance facility within its so-called reserve options mechanism (ROM) to 30 percent from 40 percent to support financial stability.

This year's lira losses come on top of a near 30 percent slide in its value last year on concerns over the independence of the central bank as well as strained relations with the United States.

Investors fear that the decision to repeat the Istanbul election on June 23 will add nearly two months of uncertainty over Turkey's plans to rebalance and stabilize the economy.

The central bank's net international reserves fell slightly to $25.84 billion in dollar terms as of May 3, data showed on Thursday, while gross forex reserves fell nearly 1% to $72.63 billion, another cause of concern for economists. (Additional reporting by Daren Butler in Istanbul Writing by Ezgi Erkoyun Editing by Dominic Evans and Gareth Jones)