June 26, 2017 / 11:41 AM / 2 months ago

UPDATE 2-Italian bond yields drop as EU approves bank rescue

* Solution shores up ailing financial sector

* But could add up to 17 bln euros to state debt

* Greek borrowing costs lowest since 2009 after upgrade

* Euro zone periphery govt bond yields tmsnrt.rs/2ii2Bqr (Updates prices for close)

By Abhinav Ramnarayan

LONDON, June 26 (Reuters) - Italian government bond yields fell on Monday after Rome received the go-ahead to wind up two failed lenders, shoring up its ailing banking system which is seen as a drag on growth.

The European Commission ended months of speculation over whether Italy would be able to bypass regulations preventing state bailouts of banks by granting approval for the deal.

On Sunday, Italy began winding up two failed regional banks in a deal that could cost the state up to 17 billion euros ($19 billion). The rescue will see the lenders' good assets go to Italy's biggest retail bank, Intesa Sanpaolo.

The Italian banking system is choked by a high level of bad loans and the prospect of some relief was enough for investors to buy up Italian bonds despite the additional borrowing such a rescue entails.

"Negative consequences for the Italian state will be offset by the positive consequences for Italian government bonds in terms of reducing the already high uncertainty surrounding this issue," BBVA strategist Jaime Costero Denche said.

Indeed, after an initial spike in early trade, Italian government bonds were among the best performers on the day by noon.

The yield on 10-year Italian debt dropped as much as 4 basis points to 1.87 percent, before edging back up to 1.90 percent as European trading drew to a close.

Most other euro zone government yields were flat on the day.

"There is the danger that other banks need state support, but I think there's more clarity now that there is a solution for the banking sector," ING strategist Martin van Vliet said.

Italy's bond yield spread over Germany see-sawed from 168 bps in early trade to 164 bps by midday.

BBVA strategists believe that if the entire 17 billion euros is used, it would add about 1 percentage point to the country's debt as a percentage of its economic output. Italy's debt-to-GDP ratio is among the highest in the world at 132.6 percent at the end of 2016, according to EU data.

Italy's economy minister said on Monday he did not expect other banks to need state aid.

Also on Monday, Greece's 10-year borrowing costs dropped to their lowest since 2009 after Moody's upgraded its credit rating on Friday, with yields approaching levels at which Athens might consider returning to the bond market.

For Reuters Live Markets blog on European and UK stock markets see reuters://realtime/verb=Open/url=http://emea1.apps.cp.extranet.thomsonreuters.biz/cms/?pageId=livemarkets

Editing by Alison Williams

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