By Silvia Aloisi
MILAN (Reuters) - Wary Italian banks are parking their money in government bonds rather than using it to boost business activity by lending to firms, signaling no let-up in the credit crunch that is crippling the euro zone's third largest economy.
Lending to non-financial companies fell 1.5 percent in June from a year earlier, Bank of Italy data showed on Wednesday, extending a 0.4 percent decline in May which was the first drop in the figures since July 2010.
At the same time, the banks raised their holdings of domestic sovereign bonds to 316 billion euros from 302.5 billion at the end of May.
The lenders have benefited from a glut of cheap European Central Bank funds and higher customer deposits, but rising levels of bad debts have made them increasingly reluctant to extend credit to the private sector.
Instead, some of the ECB funds - borrowed by Italian and other euro zone banks over three years at ultra-low interest rates in tenders held in December and February - are being used to help cover Rome's financing needs.
Yields and risk premiums on the country's debt have risen towards danger levels in recent months as Italy has been dragged deeper into the euro zone debt crisis, leading to reduced demand for the bonds from foreign investors.
Meanwhile, Italian banks' holdings have risen more than 100 billion euros since before the first ECB tender.
Tougher pan-European regulations have forced banks to strengthen their capital base to better guard against economic shocks, and this too has made them more selective in lending.
The country's two biggest lenders, Intesa Sanpaolo <ISP.MI> and UniCredit <CRDI.MI>, both reported on Friday a sharp rise in the amount of money they had to set aside in the second quarter to cover risky loans.
UniCredit's Chief Executive, Federico Ghizzoni, said he expected bad loans to rise through the end of 2012.
The Bank of Italy said they had increased by 15.8 percent in June, a similar growth rate to that of May.
Italy shrank further into recession in the second quarter, data showed on Tuesday, undermining attempts by Mario Monti's technocrat government to keep the country's finances under control.
With unemployment at a record high, Italians are growing wary of Monti's bitter austerity medicine and also frustrated at the lack of decisive action from European policymakers to address the region's crisis.
But Italian savers are not yet pulling their money out of the country, as is happening in Greece and, to some extent, in Spain.
Deposits at Italian banks rose 2.9 percent in June, the strongest increase in more than a year, the Bank of Italy figures showed.
(additional reporting By Gabriella Bruschi; Editing by John Stonestreet)