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* Markets fear eurosceptics may take power
* They could row back on market-friendly reforms
* Banks down 3 percent; bond yield gap vs Germany widens
* Berlusconi’s Mediaset down on poor Forza Italia results
By Valentina Za and Danilo Masoni
MILAN, March 5 (Reuters) - Italian bonds and banking stocks took the brunt of a market sell-off on Monday after a national election delivered a hung parliament and strong gains for anti-establishment parties.
The prospect of power passing to a eurosceptic coalition, which might boost spending in defiance of EU budget restrictions and row back on the previous government’s market-friendly reforms, turned the spotlight on Italy’s 2.3 trillion euro public debt pile, one of the world’s biggest.
Its banks hold around 345 billion euros ($425 billion) of that debt and are considered a proxy for sovereign risk.
“Italy is far from having sorted its long-standing problems, and now it will have new ones,” Lorenzo Codogno, founder of LC Macro Advisors, said. “Be prepared for long and complex negotiations that will take months.”
By 1422 GMT Italy’s main stock index lost 1.3 percent as investors awaited more clarity on possible coalitions but took some comfort from an economic expansion that hit a seven-year high in 2017.
The banking index was 2.9 percent lower.
Benchmark 10-year bond yields stood at 2.11 percent after rising to 2.14 percent at the open, their highest level since October.
Italian bond yields risked spiralling out of control during the sovereign debt crisis of 2011-2012 and were only reined in by the European Central Bank’s ultra-expansionary policies, which are being scaled down.
With Bunds strengthened by the prospect of a new government in Germany after Social Democrats voted to join forces with Angela Merkel’s conservatives, the yield premium Rome pays over Berlin on 10-year debt rose to 1.54 percentage points, the highest since January.
“The spread refrain has started anew but who cares ... Italians decide when it comes to Italy ... markets have nothing to fear,” said Matteo Salvini, head of the anti-immigrant League which emerged as the main party in a rightist alliance that got the biggest bloc of votes.
Boosted by Italy’s fastest growth in seven years and expectations of a tighter monetary policy, Italy’s banking index hit a near two-year high in February after state rescues last year removed the threat of a systemic crisis.
The outgoing centre-left government also passed measures to help lenders shed problem debts and encouraged mergers which are seen as necessary to beef up profits.
Italian lenders hold 300 billion euros in soured debts after a deep recession, and their shares are seen as cheap as they trade below the value of their assets.
After Monday’s drop, the banking index is still 6.5 percent higher year-to-date but it is seen as vulnerable to a worsened economic outlook.
“The prospect of a prolonged period of domestic political uncertainty risks weighing on the ongoing recovery,” said Nicola Nobile of Oxford Economics.
Mid-sized Italian banks with domestically focused operations and high bad loan burdens were worst hit. BPER Banca lost 6.4 percent, Banco BPM 5.3 percent and UBI Banca 4 percent.
Heavyweights Intesa Sanpaolo and UniCredit lost only around 2 percent.
The 5-Star Movement that won the most votes of any party has promised to compensate further small savers left out of pocket by a string of banking crises, and wants to split lenders’ commercial and investment banking businesses.
“Although the season of bank bailouts is virtually over, Italy should not let its guard down,” Lazard’s Managing Director Massimo Pappone said. “Key issues are at stake: bank lending ... and the handling of so-called unlikely-to-pay loans (to borrowers in trouble but not yet insolvent), which can be a lever to support the economy.”
Another notable Italian loser, with shares dropping 6 percent, was broadcaster Mediaset, which is controlled by the Berlusconi family and is mired in a legal spat with French media group Vivendi over a derailed pay-TV deal.
Berlusconi’s party’s poor results in the election are seen weakening Mediaset’s bargaining power.
$1 = 0.8118 euros Additional reporting by Giulio Piovaccari and Andrea Mandala, editing by John Stonestreet