Italy banking outlook negative as asset quality slides: Moody's

MILAN (Reuters) - The outlook for Italy's banking sector remains negative, Moody's said on Monday, citing rapid asset quality deterioration and limited access to market funding.

In a report, Moody's said the operating conditions for the banks were difficult and would remain challenging.

"Moody's expects that the banks' asset quality will continue to deteriorate over the outlook period, from already weak levels," it said.

Bad loans at Italian banks, a major concern for investors, rose by 15.3 percent in September as the euro zone crisis continues to take its toll on the real economy.

Earlier on Monday, central bank sources said the Bank of Italy had told domestic lenders to make adequate provisions for rising bad loans and keep restructuring their operations to cut costs.

"The banks' already modest profitability will also continue to weaken, as loan-loss provisions will increase and continue to absorb a higher portion of banks' moderate pre-provision earnings," Moody's said.

Italy's two biggest banks Intesa Sanpaolo (ISP.MI) and UniCredit (CRDI.MI) set aside a combined 8.4 billion euros ($10.2 billion) in the first nine months of the year in the face of rising bad loans.

Last week, the chief executive of UniCredit said he did not expect bad loans in Italy to improve before mid-2013 due to a deep recession.

Rising non-performing loans have forced Italian banks to cut lending to businesses, crimping profits and exacerbating a credit crunch in the euro zone's third largest economy.

In its report Moody's said euro area-wide pressures would continue to restrict Italian banks' access to market funding.

It also said that while the banks had strengthened their balance sheets, capital levels remained vulnerable and below those of other large European banking systems.

(Reporting by Stephen Jewkes; Editing by Leslie Gevirtz)