Shares in UniCredit SpA and other Italian banks extended losses on Monday after a sell-off last week due to concerns Italy could be drawn into the euro zone debt crisis and worries about the strength of their capital.

UniCredit, Italy's biggest bank by assets, turned negative after seesawing in early trade and was down 0.7 percent at 1.22 euros by 1123 GMT, adding to a 20 percent drop over the past week.

On Friday alone, the stock fell 7.9 percent, leading Italian banks down and weighing on Milan's FTSE MIB blue-chip index.

Intesa Sanpaolo SpA , Italy's biggest retail bank, fell 5.6 percent after briefly advancing into positive territory following last week's 13.5 percent drop.

Italian banks have been hit mainly by fears that Italy, which has one of the world's biggest public debts and is the euro zone's third-largest economy, could be sucked into the debt crisis that has forced Greece, Ireland and Portugal to take bailouts.

Underscoring those concerns, the premium investors demand to buy Italian bonds instead of German paper shot to a euro lifetime high on Monday.

The 10-year yield spread between Italian and German debt widened to 268 basis points ahead of an emergency European Union meeting on Greece and the worsening situation in Italy.

The higher spread in turn weighed on banks, which hold around 200 billion euros ($290.2 million) of Italian debt and are seeing their funding costs rise.

It is the high reliance on wholesale funding markets and the elevated holdings of domestic government bonds that leaves Italian banks vulnerable, said analysts at JP Morgan.

They said Italian banks' government bond holdings as a percentage of their assets stood at 6.33 percent, second only to Greek banks at 10 percent.

This increases the sensitivity of Italian banks to their own sovereign, risking a creation of a vicious circle.

Worries about exposure to Italy also hit shares in French banks. According to data from the Bank for International Settlements, foreign banks' exposure to Italy stood at $1.097 trillion at the end of December, and French banks accounted for 35 percent of that.

UNICREDIT HIT HARDEST

In an attempt to curb price volatility after Friday's sell-off, Italian market regulator Consob introduced new disclosure requirements on short-selling on Sunday.

UniCredit, the only big Italian bank that has not carried out a capital increase in recent months, has been hit harder than its Italian peers by expectations that it will need to boost its capital base after the results of EU-wide stress tests are made public later this week.

Also weighing on the stock is the fate of Libya's 7.5 percent stake in the bank, which is frozen because of international sanctions against Libyan leader Muammar Gaddafi.

UniCredit CEO Federico Ghizzoni said in a newspaper interview on Monday that the bank has had signs of interest in the stake and hopes for a quick clarification of the situation in Libya.

The Central Bank of Libya holds just under 5 percent of UniCredit and the Libyan Investment Authority has 2.6 percent.

Asked what would happen if Tripoli wanted to pull out of UniCredit at short notice, Ghizzoni said: I believe that they would not have trouble doing it through us or by themselves. The signs of interest are there already.

Asked about a capital increase, Ghizzoni said UniCredit was waiting for clarification about regulators' norms on systemically important financial institutions.

He said he was unconcerned about capital levels, adding: Today we all agree that capital should be higher than in the past. But I don't agree about raising capital to such a level that there are significant problems with profitability.

(Additional reporting by Michel Rose, Nigel Tutt, Valentina Za and Ian Simpson and by Steve Slater in London; Writing by Silvia Aloisi; Editing by Mike Nesbit and David Holmes)

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