* Markets price in solid victory for Prime Minister Erdogan
* Hopes political tension will ease after local polls on Sunday
* Lira hits strongest level to dollar since March 7 (Updates for lira)
By Alexandra Hudson and Dasha Afanasieva
ISTANBUL, March 26 Turkish assets firmed on Wednesday in anticipation of a strong showing for the ruling AK Party in local elections on Sunday, easing months of political tensions compounded by a state graft scandal.
The lira firmed to 2.1985 to the dollar at 1543 GMT, its strongest level versus the greenback since March 7, and gaining from a level of 2.2360 late on Tuesday.
"The scenario that the AK Party is going to win the local elections with a vote percentage of over 40 percent is being priced in, and positions are taken accordingly," said a forex trader. "We see the same scenario has been priced into the stock exchange market.
"Lira appreciation could have been steeper, but local institutional demand for the dollar continues despite foreigner inflow."
After a drop of 17 percent in 2013, the lira has weakened around 4 percent this year as a corruption scandal has swirled around Prime Minister Tayyip Erdogan and his AK party. The currency touched a record low of 2.39 on Jan. 27, prompting the central bank to hike interest rates massively the next day.
Stocks also enjoyed a boost on Wednesday after the government cleared the way for the central bank to pay interest on banks' lira required reserve deposits.
The central bank has said it may take such a step in a limited capacity and if needed, to boost liquidity in the financial system and help counter any economic slowdown.
It had previously paid interest on lira reserve requirements but stopped doing so in 2010 as loosening global liquidity flooded Turkey with cheap funding while it sought to cool an overheating economy.
The government made the announcement in the official gazette published early on Wednesday.
The Turkish bank index closed up 6.94 percent on hopes of interest rate payments that would boost earnings in the sector, which has seen profits wane in recent quarters as the central bank seeks to cool consumer borrowing.
"According to our calculations, this could have a 2-3 percent effect on the earnings (for banks). Positive momentum could continue in the market today," Odeabank said in a note, adding that it expected no "immediate aggressive action" to be taken by the central bank.
The biggest jump was seen in Bank Asya after Qatar Islamic Bank said it had entered into exclusive discussions to acquire a stake in the Turkish lender.
Its shares rose more than 22 percent, although Bank Asya's limited weighting meant it was not the biggest driver of the banking sub-index.
The main Istanbul share index, within which banks make up more than half the weighting, was up 4.69 percent at 67,730.78. It outperformed the main emerging markets index , which was up 1.13 percent.
Minutes on Tuesday of its March 18 monetary policy committee meeting showed the central bank was considering paying interest to banks on the share of their lira deposits they are required to hold with it.
"It was stated that such a measure could be considered at a future date if deemed necessary," the minutes said.
"It was indicated that any decision regarding the payment of partial interest to reserve requirements to be implemented in the future should be measured and limited."
Improved risk sentiment globally provided additional support for Turkish markets, amid perceptions that geopolitical tensions over Ukraine are easing. The United States and its G7 allies agreed on Tuesday to hold off on more damaging economic sanctions against Russia unless it goes beyond the seizure of Crimea.
The news that Moscow's and Kiev's foreign ministers had held an impromptu first meeting also led investors to believe the crisis is not heading into a wider armed conflict.
Turkey's 10-year benchmark bond yield fell to 10.8 percent from 11.06 percent at Tuesday's close. (Additional reporting by Nevzat Devranoglu, Ece Toksabay, Editing by Catherine Evans)