A DEEPENING recession and banking stress tests could find Italy's mid-sized lenders short of billions of euros, putting the state on the hook for a new wave of cash calls and triggering an overhaul of how they do business.

Even ahead of the European stress tests, expected to take place when or shortly before the European Central Bank (ECB) takes over direct supervision of eurozone banks next year, Italy's smaller banks are under pressure to boost their balance sheets after a Bank of Italy audit of problematic loans and to meet stricter Basel 3 capital rules. Bad loans in Italy have been climbing at an annual rate of 20 percent in recent months.

In the port city of Genoa, birthplace of modern banking in the 15th century, regional market leader Carige is raising 800 million euros (US$1 billion), equivalent to two thirds of its market value, by selling assets to boost its capital.

With a core Tier 1 ratio of 6.7 percent, Carige's ability to absorb losses is among the weakest in Italy.

"Initially, we thought we would have more time to come into line with the new Basel 3 rules," Ennio La Monica, the bank's chief executive, said in an interview. "But there was an acceleration in September with the drafting of the list of banks that would fall under EU banking supervision."

"This problem is common to a number of other small banks. We had to speed up and try to do everything this year," said La Monica.

Disposals and other actions undertaken by the bank should boost its core Tier 1 to 10 percent, he added.

Italian banks' efforts to shore up their capital base, especially among the 25 or so lenders expected to come under ECB supervision, is in turn deepening the country's economic recession, as they cut back on lending.

A harsher credit crunch could emerge if the ECB stress tests expose more capital holes, potentially prolonging Italy's nearly two-year-long recession and raising its debt burden, already at 2 trillion euros, the second-largest in the EU after Germany, which has a much bigger economy and a much lower ratio of debt to GDP.

With bad debts mounting, analysts expect the Frankfurt-based central bank to take a harsh look at the quality of banks' loans, requiring them to set aside more capital.

While Italy's top five banks - UniCredit, IntesaSanpaolo, Monte dei Paschi, UBI and Banco Popolare - have already raised around 26 billion euros in fresh capital from investors since 2008, mid-sized players are lagging behind.

With non-performing loans now representing between 5 and 19 percent of Italian banks' loan books, analysts who carried out simulations of the ECB stress test estimate a possible capital hole of 40-60 billion euros in gross terms, before items such as the banks' own earnings are deducted.