* Banks to pay just 61.1 bln euros in loans, less than forecast * EU Commission forecasts euro zone economy to shrink * Markets wary ahead of Italian election By Gertrude Chavez-Dreyfuss NEW YORK, Feb 22 The euro dropped to a six-week low against the dollar on Friday on news that euro zone banks were to repay fewer crisis loans than expected to the the European Central Bank. The ECB said banks will repay 61.1 billion euros of the second of two crisis ECB three-year loans they took a year ago. That was the less than half the amount expected by the market, casting doubts on the health of the region's financial system. Some investors said the data signalled some banks still felt the need to keep hold of the ultra-cheap emergency loans, and means the ECB's balance sheet will shrink at a slower pace. "This means that the confidence is still not there and that's a negative for the euro," said Sebastien Galy, currency strategist, at Societe Generale in New York. "I don't think euro zone banks are confident that they can get cheaper loans elsewhere." A report from the European Commission on Friday that forecast the euro zone economy will contract again in 2013 and caution ahead of an Italian election this weekend also weighed on the euro, which fell for a third straight session. The euro fell as low as $1.3156, its lowest since Jan. 10, retreating from a session high of $1.3244 touched after a better-than-forecast German Ifo survey suggested a brighter outlook for the euro zone's largest economy. It was last down 0.1 percent on the day at $1.3178, with market players reporting supporting bids around $1.3150-60. Europe's common currency was on pace to close lower for a third straight week. The euro has come under heavy pressure against the dollar since minutes on Wednesday fuelled speculation U.S. policymakers may start to tighten monetary policy earlier than thought. Some strategists said they expected the euro to grind lower ahead of the Italian elections, although it should find support around $1.3040, near the Jan. 10 low of $1.3037. Investors were wary about the risk of a fragmented Italian parliament or resurgence from former prime minister Silvio Berlusconi, which could hinder the euro zone's third largest economy from fighting its longest recession in 20 years. Market participants in general are taking a more defensive position -- betting on the euro's downside -- in case of an adverse outcome in Italy. The result of the Italian vote is not expected until next week. Bob Lynch, chief currency strategist at HSBC in New York said he continues to expect a weaker euro due to a host of technical factors. "The downward shift in momentum indicators, the break below the July 2012 uptrend, and the further shift in relative yield spreads against the euro suggest to us that the risks remain on the downside in the near-term," said Lynch. YEN WEAKNESS The euro and the dollar rose against the yen, although strategists said the Japanese currency's three-month decline was showing signs of losing momentum. Expectations the new Japanese government will take aggressive easing steps in an attempt to revive the economy have helped the yen fall steeply across the board since November. The dollar rose 0.4 percent on the day to 93.46 yen, keeping some distance from a 33-month high of 94.47 hit last week. The euro edged up 0.3 percent to 123.18 yen. Some market players said the fact U.S. policymakers had not particularly objected to yen weakness, which makes Japan's exports more competitive relative to those of other countries, meant the downtrend could continue. "We didn't really realise how aggressive the Japanese officials would get and we also didn't really sense the U.S. condoning it as much as they did," said John Vail, chief global strategist at Nikko Asset Management. "It could be that they (the U.S.) are quite willing to let the yen get to this level. My sense is that the 95-105 yen level is the intended range." Meanwhile, the Australian dollar regained ground after falling to a four-month low of US$1.0221 against a broadly stronger U.S. currency on Thursday. The Aussie rose 0.5 percent to US$1.0307.