* Banks write down bad loans before Europe-wide checks
* Italian lenders seen as cheap play on economic recovery
* Italy no longer cause for alarm among foreign investors
* Clean up should allow banks to boost lending
MILAN, March 12 (Reuters) - Italian banks are setting aside billions of euros to cover for years of bad loans accumulated as the economy soured, in a long-overdue balance sheet clean-up that could preface better times for the euro zone's third-largest economy.
Italy's largest bank by assets UniCredit and troubled lender Monte dei Paschi di Siena this week announced the write-downs - of 13.7 billion and 2.75 billion euros respectively - as they prepare for an industry-wide health check that European lenders are undergoing this year.
Intesa Sanpaolo is also expected to raise sharply its provisions for souring debts when it releases financial results later this month.
The write-downs, which led to much bigger 2013 losses than had been expected, are one of the hoped-for effects of the "asset quality review" by the European Central Bank: forcing lenders across the continent to deal with years of hidden losses so that the economy can get on a firmer footing again.
In Italy, bad loans are the number one problem for banks as small and medium-sized businesses that are the core of the economy increasingly defaulted during a 2-1/2 year recession. In January this year, bad loans totalled 160 billion euros ($220 billion) - more than double their level in 2010 - and they are expected to rise to nearly 200 billion euros in 2015.
The bad debts - and little disclosure of them - had scared investors away from the banking sector, which in turn has been starving consumers and businesses of credit.
But the economy is finally showing signs of recovery - albeit a slow one - with gross domestic product rising 0.1 percent in the fourth quarter of last year, the first positive sign after nine quarters of recession.
The stock market cheered the banks' spring cleaning, pushing UniCredit's shares up 6 percent on Tuesday and Monte dei Paschi's 4 percent higher on Wednesday.
Investors said they were encouraged because Italian lenders are seen as a cheap play on the country's recovery, provided they clear the decks before the good times return. With the euro zone crisis having subsided and confidence gradually returning, the banks can now grasp the nettle.
"The mood has completely changed. If Italian lenders had carried out this kind of book cleansing a year ago the reaction would have been very negative. But now Italy is no longer cause for alarm among foreign investors," said Mario Spreafico, head of private banking at Schroeders in Italy.
Explaining why UniCredit had opted for such a big hit all in one go, resulting in a record 2013 loss of 14 billion euros, CEO Federico Ghizzoni said it was a "courageous decision" the bank needed to turn the page and move on. "Admit it, this time I surprised you," he quipped with reporters.
Mediobanca Securities analysts praised the move. "This is the visibility moment we were hoping for and will force investors sceptical on the asset quality of the bank to look at it from a different standpoint: the recovery story," they said in a report.
For years, Italian banks turned a blind eye to their growing bad loans because writing them down to market value would have opened a big hole in their accounts and required them to set aside even more capital. But with its review, the ECB is forcing banks to come clean or risk being shut down.
Seven of the 15 Italian banks being scrutinised by the ECB have already announced capital increases totalling nearly 8 billion euros as they move to restore their financial strength before the results of the review are announced in October.
In addition to bad loans, the peculiar ownership structure of Italian banks - many have politically-influenced foundations as core shareholders - has put off investors, and that is unlikely to change soon.
With their focus on retail banking, high costs and overlarge branch networks, Italian lenders have also historically posted low profits.
Still, relatively cheap valuations as measured by their price to book ratio - their market capitalisations compared with the value of their net assets - are playing in Italy's favour, especially if the balance-sheet clean-up continues.
Banks in Italy have an average price to book ratio of 0.6, compared with 1.0 for Spain and 0.8 percent for Ireland - two countries where lenders were heavily restructured as part of European bailouts.
Analysts say that improving the books is not only a question of investor confidence. With cleaner balance sheets, banks can provide much-needed credit that can fuel the economic recovery.
Tellingly, both UniCredit and Monte dei Paschi reported they had cut lending by 8 percent over the past year as they tried to strengthen their capital at the request of regulators.
"By cleansing their bad loan portfolios banks can stop acting like zombies and restart the lending cycle which right now is pretty much blocked," said Massimiliano Saccone, head of Milan-based investment consultancy XTAL Strategies.
But money won't be flowing freely yet. UniCredit promised on Tuesday a return-on-equity - a measure of how much profit a company generates with the money shareholders have invested - of 13 percent by 2018.
But that ratio was negative for the whole Italian banking industry in 2012 and just above zero in 2013.
Bailed-out Monte Paschi is struggling to avoid nationalisation with a 3 billion euro rights issue and will not pay a dividend for at least another three years.
There are also hundreds of cooperative lenders with a "one stake, one vote" rule giving all investors the same say, irrespective of the size of their holding, and helping to prolong a governance model which critics say is outdated and opaque.
In a sign of the difficulties in bringing about change, Popolare di Milano's top shareholder - a private equity fund - sold its stake in January after its bid to make the bank more attractive for investors was defeated by unions.