UPDATE 2-Bank of Italy says public money needed to help banks

* Italy pressing Brussels to allow state help for its banks

* Italy’s banks hit by market sell-off, need capital

* Bank of Italy chief warns of threat to financial system (Adds economy minister, more quotes)

ROME, July 8 (Reuters) - Bank of Italy Governor Ignazio Visco said on Friday that public money should be used to help Italy’s troubled banks in a financial system which is “full of risks” following Britain’s decision to leave the European Union.

Italy’s banks are saddled with some 360 billion euros ($400 billion) of bad loans and their shares have been hit by heavy selling this year, which has intensified in the wake of last month’s referendum in Britain.

Visco said the current market situation was “full of risks for financial stability,” and a public backstop to support the banks was necessary and was not prohibited by European rules.

Italy has been in talks with the European Commission to devise a plan to recapitalise its lenders with public money, limiting the losses for bank investors which are required by EU rules.

“We are confident of the possibility of success for a common commitment to overcome the current difficulties,” Visco told a conference of Italian bankers.

Economy Minister Pier Carlo Padoan, speaking at the same conference, said EU rules allowed for flexibility on state aid for banks and this must be used to the full in the current circumstances.

The government is in “continuous dialogue” with Brussels “to explore all means of public intervention allowed by EU regulations,” Padoan said.

Italy’s fragile economy, and Prime Minister Matteo Renzi, can ill afford a full-blown banking crisis. Economic growth is seen by most economists at below 1 percent this year and lower in 2017.

“Renzi needs to deliver greater confidence in the Italian financial system ... or face the real risk of Italy being thrown into another recession after just exiting its longest post-war one at the start of 2015,” said Raj Badiani, senior economist at IHS Global Insight.

ECB Vice President Vitor Constancio said on Thursday that the plight of Europe’s banks may need some “small” state support .

Visco, who sits on the European Central Bank’s policy-setting governing council, warned of potential systemic effects of a banking crisis for single EU member states and for the euro zone as whole.

However, he also said a large part of the soured credit in Italy was held by banks which are in sound financial condition.

“It is wrong to speak of the problem of bad loans as an emergency for the whole banking system,” he said.

Italy has moved to try to consolidate its fragmented banking system, and Visco said that after the recently announced merger between Banco Popolare and Banca Popolare di Milano, he expected other mergers or takeovers “before too long.”

He said that in the current situation it was essential that EU policy makers be ready “to limit market tensions, ensure liquidity, reinforce the banking system and support confidence.”

He also warned that a too-rigid application of bank supervision rules should not “become a source of tension in itself.”

$1 = 0.9033 euros writing by Gavin Jones, editing by Toby Chopra