In a keynote speech in Parma, Bank of Italy chief Ignazio Visco said the country's banking system was solid but high costs and recession meant lenders' earnings prospects this year were "not favorable."

"Italian banks are sound, but they have been especially hard hit by the sovereign debt strains," he said.

Highlighting funding strains, he said that in 2011 banks' fundraising from customers and markets declined by 2.8 percent, while their reliance on borrowing from the European Central Bank increased.

European Central Bank funding to Italian banks stood at around 200 billion euros ($262.8 billion) in January, up from just over 40 billion last June.

Thanks to measures taken recently by the Bank of Italy, and allowing domestic banks to use banking loans as collateral for ECB funds, the total collateral available to the lenders will rise to nearly 450 billion euros, Visco said.

Italy has taken steps towards financial sustainability once deemed inconceivable, Visco said, but much remained to be done both domestically and at the European level.

At home, "the reforms decided must be rapidly completed and put into effect, in particular those to make the regulatory and administrative structure favorable rather than unfriendly to economic growth."

The economy, which fell into recession in the fourth quarter of last year, will shrink by around 1.5 percent this year, Visco estimated, in line with economists' forecasts. The economy grew 0.4 percent last year, according to an official preliminary estimate.

Parliament is currently debating government proposals to deregulate some service sectors and reduce red tape, and Prime Minister Mario Monti is negotiating plans for a reform of the labor market with trade unions.

Improving education and training and reforming the justice system to speed up verdicts were urgent priorities, Visco said.

PRESSURE EASED

Market pressure on Italy has eased since November, when the spread between its benchmark bonds and safer German bunds hit a high of around 550 basis points (5.5 percentage points) and Italy's debt crisis looked fatal to the whole euro zone.

The spread now stands at around 365 basis points, compared with around 200 during the first half of last year.

"The markets' attention is now focused on Italy's ability to make further determined progress in the restoration of its public finances and simultaneously stimulate its economic growth potential through structural reforms," Visco said.

However, more than 80 billion euros of budget cuts since last summer and an important pension reform meant public finances are already on a sustainable path in coming years even under unfavorable assumptions for growth and interest rates, he said.

Pressure on Italy has been reduced by interest rate cuts and the ECB's offer of cheap three-year loans to banks, but Visco said monetary policy alone could not solve the problems of Italy or the euro zone.

The financial support mechanisms at European level must be made to work with greater agility and more effectively, he said, and "the threat of dangerous contagion must be definitively dispelled by resolving the problem of Greece."

On Monday euro zone finance ministers are due to hold a crunch meeting to decide whether Greece has done enough to secure a new rescue package of 130 billion euros needed to stave off default.

Italian banks were the biggest takers of ECB loans when the central bank launched its first three-year refinancing operation last December - they borrowed a whopping 116 billion euros. The ECB will hold a similar operation on February 29.

Loans by banks to companies declined by 20 billion euros in December, Visco said, calling the reduction "very marked." This was partly due to the banks' higher funding costs.

"According to preliminary data, a further, slight credit contraction took place in January," he said.

"It is crucial that the economy does not fall victim to credit asphyxiation," he said.

Visco also took a swipe at ratings agencies, saying they had "not always been up to the mark," and calling on them to work with independent, national and supranational bodies in carrying out their assessments of sovereign risks.

(Editing by Susan Fenton)

• A Permanent Economic Emergency