UPDATE 1-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 government bond holdings, details)

By Silvia Aloisi

MILAN, Oct 8 (Reuters) - Italian banks are parking their money in domestic government bonds rather than lending it to businesses, central bank data showed on Monday, signalling a worsening credit crunch in the euro zone's third largest economy.

Lending to non-financial companies fell by 1.9 percent in August from a year earlier, the fourth consecutive monthly decline and the worst fall since the data turned negative in May.

Overall loans to the private sector, which includes financial companies, were also down, by 0.2 percent, the first contraction since February 2010, the data from the Bank of Italy showed.

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

The lenders have benefited from a glut of cheap European Central Bank funds and higher customer deposits, but rising levels of bad debts have made them increasingly reluctant to extend credit to the private sector.

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

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

Tensions on debt markets have eased over the past month after the ECB pledged to conditionally buy bonds of troubled euro zone countries. The yield on Italy's 10-year bonds stood at 5.09 percent on Monday compared to 5.85 percent in early September.

That has prompted some of Italy's biggest banks - including Intesa Sanpaolo , UniCredit , Mediobanca

and Banco Popolare - to tap wholesale funding markets, which had largely shut them out at the peak of the euro zone debt crisis.

Tougher pan-European regulations have forced banks to strengthen their capital base to better guard against economic shocks, 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 annual growth of 15.6 percent in August from 15.4 percent a month earlier.

With Italy's economy forecast to be in recession this year and next, credit quality deterioration is becoming a top concern for investors. In a recent report, Morgan Stanley analysts said bad debts at Italian lenders would probably approach 10 percent of the loan book at the end of 2013.

On a brighter note, Italian savers are not pulling their money out of the country, as has happened in Greece and, to some extent, in Spain.

Private sector deposits at Italian banks rose 3.5 percent in August, the first time since February 2010 they have grown by more 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/