* Italian bonds slide, pull periphery wider * Spread between 10-year BTP and Bund hits new euro-era high * UniCredit, Intesa San Paolo lead bank shares down * Contagion fears, higher bond yields weigh on Italy banks * EU finance chiefs meeting to discuss Greece, Italy (Recasts with bonds, EU meeting, analyst comment) By Silvia Aloisi MILAN, July 11 (Reuters) - Italian government bonds and stocks fell sharply on Monday as investors cut their exposure to Italy on fears the euro zone's third biggest economy could be sucked into the bloc's sovereign debt crisis. The premium investors demand to hold Italian paper rather than low-risk German debt rose to a new euro lifetime high, pushing up financing costs for Italy -- which has one of the highest public debts in the world -- and its banks. With euro zone finance ministers and officials due to meet later on Monday to discuss a second bailout for Greece and the worsening situation in Italy, the spread on the 10-year Italian BTP widened to 290 basis points over Bunds. The benchmark bond's yield climbed to 5.565 percent -- the highest in 10 years. The cost of insuring Italian debt against default also jumped to a new record high. Gary Jenkins, head of fixed income at Evolution Securities, said that while Italy was still a long way from the tipping point in terms of bond yields -- markets have focused on yields of 7 percent as unsustainable -- things could quickly get out of control. "Italy with a debt to GDP ratio of 120 percent and debt of 1.6 trillion euros is a pretty big elephant to have in the room ... you have to stop the contagion getting to Italy," he said. As worries the crisis will spread to Italy weighed on European bond and stock markets, Italian banking shares -- seen by analysts as a cheap way to short positions on Italy's debt, given the lenders' vast holdings of government paper -- extended losses following a big drop last week. UniCredit, Italy's biggest bank by assets, was down 3.7 percent at 1.1860 euros by 1334 GMT, adding to a 20 percent slide over the past week and weighing down the blue chip index, which fell by 3 percent. Intesa Sanpaolo SpA , Italy's biggest retail bank, fell 5.6 percent following last week's 13.5 percent drop. Analysts said Italian banks and its government debt were caught in what one called a "vicious circle". "Apparently big macro hedge funds shorted Italian banks in order to defend and enhance their long Bund vs short BTP trade performance. There is serious money in that trade," said Mediobanca analysts. "Shorting Italian banks is an indirect and easy way to affect the Italian BTP spread. Normally we see the credit market affecting the equity in the banks sector. This time it's the other way around." The higher spread weighed in turn 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. Asked about a capital increase in an interview with Corriere della Sera daily, UniCredit CEO Federico Ghizzoni said the bank 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 in Italy and by Steve Slater in London; Editing by Catherine Evans) ($1 = 0.689 Euros)

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