Italian banks shed domestic sovereign debt after fall in yields

* First quarter bond rally triggered sales by some banks

* Diversification led to buying of higher-rated bonds

* Regulators debate measures such as concentration limits

MILAN, May 21 (Reuters) - Falling returns on Italian government bonds have led some of the country’s banks to reduce their holdings in a move likely to please regulators who favour more diversification of risk.

Selling into a rally fuelled by the European Central Bank’s decision to buy government bonds, Italian banks sold 7 billion euros ($7.8 billion) of domestic bonds in March and spent 5 billion euros on other euro zone debt instead, ECB data showed.

Unlike for loans, banks do not need to set aside capital against government bond holdings but the sovereign debt crisis has called that privilege into question.

International banking regulators are reviewing rules on how banks treat sovereign debt on their balance sheets, with a view to making it less attractive for them to hold too much of their country’s public debt.

Mid-sized Italian bank Credem said last week it had cut the weight of Italian bonds in its securities portfolio to 13 percent at the end of the first quarter from 56 percent three months earlier.

Credem said it saw little room for Italian government bond prices to rise. Instead, it bought debt issued by the European Investment Bank, which is rated triple A, and bonds from northern European countries.

Italian government bond yields hit record lows in March, with 10-year benchmark yields touching 1 percent.

But even after a violent sell-off in euro zone bond markets, the 10-year yield is still just below 2 percent, well below levels close to 4 percent early last year and peaks of 6-7 percent during the sovereign crisis.

Other banks trimming Italian holdings include UBI Banca , which cut the nominal value of its domestic sovereign portfolio by 5 percent in the first quarter, selling 800 million euros of bonds.

Banca Popolare di Milano will start reducing its Italian bond holdings when improving growth leads to a sustained expansion in lending, CEO Giuseppe Castagna said last week.

TRACTION?

The question is whether the trend of cutting Italian bond holdings, led by the country’s biggest bank Intesa Sanpaolo last year, will gain traction.

A study by Bank of Italy staff shows in 2007 domestic government bonds were roughly 5 percent of Italian bank assets. The study argues there would be no incentive in loading up with more government bonds, under normal circumstances.

But during the sovereign crisis, Italian and Spanish banks took up the slack left by foreign buyers, piling into government bonds and benefiting from the high returns to beef up revenues.

While net purchases since mid-2014 total just 600 million euros, according to the Italian central bank, domestic government bonds still accounted for 10 percent of total bank assets, or 392 billion euros, at the end of March.

An expert report backed by European Central Bank President Mario Draghi published in March outlined a number of options to address the issue, including introducing concentration limits.

“Regulatory discussions over rules to limit banks’ sovereign exposure combined with lower yields may encourage some lenders to consider cutting their domestic sovereign holdings,” said Andrea Resti, banking and finance professor at Milan’s Bocconi University.

Intesa cut its portfolio of Italian government bonds by nearly 21 billion euros last year to reduce concentration risks. While its domestic sovereign exposure rose slightly in the first quarter, Italy accounted for 55 percent of its government bond portfolio, down from 80 percent a year earlier.