* Intesa considers setting up internal bad bank-source
* UniCredit sells 700 mln in loans in deal to shed bad debts
* Analaysts say Italian banks need to tackle bad loans
MILAN, Feb 3 Intesa Sanpaolo is working on plans to create an internal "bad bank" for problem loans and rival UniCredit has sold a batch of bad loans as both banks seek to clean up balance sheets while European regulators conduct a health check.
Intesa, Italy's biggest retail lender, may unveil its bad bank - which would take a chunk of its 55 billion euros of gross bad debts - when it sets out a new business plan on March 28, a source close to the situation said on Monday.
"They are doing it," the source told Reuters, speaking on condition of anonymity and confirming a report in the Financial Times. "I think it could be part of the new industrial plan."
Intesa declined to comment.
Rising bad loans are a big problem for Italy's banks because the country's longest post-war recession has made it tough for companies to keep up loan payments.
The banks have had to set aside billions of euros to cover loan-loss charges partly in response to the Bank of Italy's demands to hike provisions since late 2012.
The banks' so called "sofferenze" - or the bad loans least-likely to ever be repaid - have reached 150 billion euros ($202.78 billion) and are expected to keep climbing through 2016, according to economic think tank Prometeia.
Analysts said Intesa would be sensible to clearly separate bad assets from healthy ones as it and other European banks come under scrutiny by the European Central Bank.
The ECB started its so-called asset quality review of euro zone lenders late last year but results will not be released until October. These will include stress tests by the European Banking Authority that show how banks would withstand a crisis.
Intesa's rival UniCredit announced a sale of more non-performing loans (NPLs) on Monday providing further evidence that Italy's two big banks are cleaning up their books ahead of the ECB assessment.
UniCredit said it had sold 700 million of non-performing loans to Anacap Financial Partners. In December, the bank had announced a sale of bad loans worth 900 million euros ($1.2 billion) to private equity fund Cerberus European Investments.
"We see this as an additional move by Italian banks to keep improving their balance sheets ahead of the asset quality review," Morgan Stanley said in a note.
It said a bad bank would make it easier to gauge the underlying profitability of the core business and would make it easier to sell bad loan portfolios once they are properly separated and written off.
"The separation of the core and non-core business has helped the market assign a better valuation to Lloyds, Royal Bank of Scotland and Commerzbank," it said.
Other banks may follow suit, Royal Bank of Scotland analyst Alberto Gallo said. He said Italy could do with a system-wide bad bank similar to the ones created in Spain and Ireland at the height of the euro zone debt crisis. Gallo said such a bad bank might be worth 15-20 billion euros.
Both Intesa and UniCredit have strong core capital and neither is expected to need to raise funds in the wake of the ECB assessment this autumn.
But small and medium-sized Italian lenders are on a weaker footing. Four of the 15 Italian banks to be scrutinised by the ECB are expected to tap the market for around 6 billion euros between April and July.
They are Monte dei Paschi di Siena, which must raise 3 billion euros to pay back state aid, Banco Popolare , Banca Popolare di Milano and Banca Carige .