MILAN (Reuters) - Italian banking shares fell on Monday, with a Goldman Sachs downgrade on Italy's top retail bank Intesa SanPaolo ISP.MI outweighing its strong performance in European regulatory tests.

A woman walks in front of the Banca Popolare di Milano (BPM) bank in downtown Milan, Italy, January 29, 2016. REUTERS/Alessandro Garofalo/File Photo

A spike in Rome’s borrowing costs has thrust Italian banks into the spotlight, cutting the value of their large sovereign holdings and eroding their capital reserves.

Soaring Italian bond yields are also driving banks’ funding costs higher and making it more costly for them to offload soured debts.

Despite the heightened concerns, the four Italian banks tested by the European Banking Authority in a health check of the sector fared in line with the European average of the 48 banks surveyed under the so-called adverse scenario.

Friday's results showed that even the worst-performing Italian bank, Banco BPM BAMI.MI, had a core capital ratio of 6.67 percent in the adverse scenario, well above the alarm threshold of 5.5 percent.

However, traders said the market had paid closer to attention to a Goldman Sachs note that downgraded both Intesa and smaller peer BPER Banca EMII.MI to 'sell', leaving UniCredit CRDI.MI as the only 'buy' among Italian banks.

“Intesa ... is a well-managed institution with a comfortable capital position. That said, its results will be subject to a deteriorating macro outlook,” Goldman’s note of Nov. 2 said.

With a valuation in line with Dutch bank ING's INGA.AS or Spain's BBVA BBVA.MC and at a 50 premium to domestic rival UniCredit, Intesa's position looks vulnerable, Goldman said.

Intesa reports third-quarter results on Tuesday and analysts expect its core asset management business to have suffered due to market turmoil.

“We expect a weak set of (third-quarter bank) results driven by a further slowdown of the revenue generation, especially in terms of asset management contribution,” Equita analyst Giovanni Razzoli said.

A clash between Italy’s populist government and European authorities over the country’s 2019 draft budget has hurt confidence within the euro zone’s third-largest economy.

The outlook for the Italian economy has dimmed in recent weeks. Expansion in national output stalled in the third quarter and manufacturing activity contracted in October for the first time in more than two years.

Casting further shadows are also early signs that Italian lenders are passing on their increased funding costs to clients.

“We believe current political uncertainty in Italy is having a negative impact on growth and we expect an economic slowdown that will hit banks’ profitability,” an Italian broker said.

Goldman said one of the reasons it liked UniCredit was that cost cuts, rather than revenues, were the main profit driver.

At 1220 GMT, shares in Banco BPM were down 2.6 percent, while BPER, whose shares were down 4.2 percent, was the biggest loser among Italian banks .FTIT8300.

Italy’s banking shares have lost a third of their value since the new government’s spending plans first emerged in mid-May, but analysts say further cuts to earnings’ forecasts are possible.