Italian banks may take 10 years to fix bad debt issue - Morgan Stanley

(Reuters) - Italian banks could take 10 years to reduce their level of non-performing loans (NPLs) to the European average, Morgan Stanley said on Monday, adding that setting up a "bad bank" could help.

A recession that ended in 2014 saddled Italian banks with 349 billion euros (305.94 billion pounds) in impaired debts, one third of Europe's total, while a clogged judicial system and sluggish economic growth made it tough to recover non-performing debts.

But a series of state-led steps involving capital injections and a plan to bailout Monte dei Paschi, the world’s oldest bank, have provided some relief.

"We believe progress has been made but vulnerabilities remain, with 60 billion-70 billion euros of non-performing loan disposals still in the pipeline and almost 10 years to reach European NPL levels at the current rundown rate," Morgan Stanley said.

Analysts at the U.S. bank said establishing a "bad bank" or a publicly-funded asset management company would be a key step towards resolving Italy’s NPL problem.

The idea of a bad bank is backed by European Union institutions, including the central bank and regional banking authority, but it faces opposition in Germany which balks at the prospect of a tax-payer funded bailout.

Last week, Bank of Italy Governor Ignazio Visco welcomed a European Union proposal to set up state-backed vehicles to buy bad loans from banks but said participation should be voluntary.

Ireland, Spain and Austria have all seen their financial systems and economies emerge healthier after choosing to set up a bad bank in the aftermath of the euro zone debt crisis.

Morgan Stanley remained cautious on Italian banking shares , which have risen more than 80 percent in the past year.

It said the "pathway to normalization of loan losses will be 'bumpy' with only a gradual reduction in cost of risk.”

The Morgan Stanley analysts pick Intesa (ISP.MI) and Mediobanca (MDBI.MI) as their top stock picks in the sector.

(Reporting by Vikram Subhedar and Valentina Za; Editing by Edmund Blair)