(Adds data, analyst comments, background)
By Lisa Jucca
MILAN, Nov 14 (Reuters) - The Bank of Italy will discuss how the deteriorating economic situation is affecting banks' credit quality at its annual meeting with major Italian banks next week, a source close to the central bank said on Wednesday.
The meeting, to take place on Monday, will be attended by lenders Intesa Sanpaolo, UniCredit, Banca Monte dei Paschi di Siena, Ubi Banca, Banco Popolare and Mediobanca.
Investors are watching to see if the central bank will move at some point to counter Italian banks' rising bad loans, which have jumped to 116 billion euros($147.45 billion) from 50 billion euros in 2009.
Italy's economy has been in recession since the middle of last year. In its Financial Stability Report published on Monday, the Bank of Italy said domestic banks had increased their provisions for credit risk, but said it was stepping up controls on adequate provisions for bad debt.
The report will provide the basis for discussions at the meeting, the source said.
Both Intesa and UniCredit have increased provisions against risky loans in the third quarter while Banca Monte Paschi was pushed into the red by further writedowns on bad loans.
The central bank said in its report that the flow of problematic corporate loans would continue to grow through the first half of 2013 as the economic recession bites.
By the end of June, Italy's top five banks, which hold half of the country's banking assets, had set aside enough funds to cover 40 percent of their non-performing loans, Bank of Italy data shows. Smaller banks had set aside funds worth 35 percent or less of their total bad loans.
For the whole Italian banking system, the ratio of funds reserved to cover bad loans as a proportion of total non-performing loans has slipped 12 percentage points from around 50 percent reported in 2007 and analysts say it deteriorated further in the third quarter of this year.
"We continue to see this trend as a key pressure point for the industry," Goldman Sachs said in a report last week.
If the central bank raises the bar on coverage, some of the smaller banks would become short of cash. Some analysts have suggested that Italy may have to follow euro zone peer Spain and set up a bad bank to deal with the problem of bad loans in Italy, but others say this is not an issue.
" A bad bank is not needed for Italy given private sector leverage is low, coverage of bad loans is robust and banks' liquidity is strong," Matteo Ramenghi, a banking analyst at UBS Investment Research, said.
The International Monetary Fund, however, in a report released last month that drew much criticism in Italy, said non-performing loans at Italian banks represented 10.7 percent of total loans, higher in percentage terms than the 5.6 percent for Spanish banks.
Italian banks say their credit quality is underestimated as the Bank of Italy applies, by its own admission, a stricter definition of what constitutes a non-performing loan than the definition used by other countries.
"Italian underlying quality is significantly under-appreciated," Intesa Sanpaolo's Chief Executive Enrico Cucchiani told an analyst presentation on Wednesday. "Definitions set by the central bank are more stringent (in Italy) than elsewhere." ($1=0.7867 euros) (Additional reporting by Jennifer Clark in Milan and Laura Noonan in London; Editing by Susan Fenton)