MILAN/ROME (Reuters) - Italy began winding up two failed regional banks on Sunday in a deal that could cost the state up to 17 billion euros ($19 billion) and will leave the lenders’ good assets in the hands of the nation’s biggest retail bank, Intesa Sanpaolo.

The government will pay 5.2 billion euros to Intesa, and give it guarantees of up 12 billion euros, so that it will take over the remains of Popolare di Vicenza and Veneto Banca, which collapsed after years of mismanagement and poor lending.

Economy Minister Pier Carlo Padoan said the total funds “mobilized” by the state would be for up to 17 billion euros - three times more than had initially been estimated to recapitalize the banks with public money.

The deal, approved by the European Commission, allows Italy to solve a banking crisis on its own terms, ensuring the two Veneto lenders are not wound down under potentially tougher European rules. The cost for taxpayers, however, is hefty.

“Those who criticize us should say what a better alternative would have been. I can’t see it,” Padoan told reporters after the government spent the weekend drafting an emergency decree to liquidate the two banks.

The decree effectively means that the Veneto banks’ branches and employees will be part of Intesa Sanpaolo by Monday morning, a move designed to avoid a potential run on deposits that could have spread chaos across the whole banking industry.

The decree will have to be voted into law by parliament within 60 days.

Under the plan, the banks’ soured loans, as well as legal risks stemming from a mis-selling scandal, will be moved to a bad bank, partly financed by the state. Junior bondholders and shareholders in the two banks will suffer losses, but senior bonds and depositors will be protected.

Padoan said that on top of the 5.2 billion euros payment to Intesa, which includes 1.3 billion euros to cover job cuts, the state will offer guarantees to fund potential losses arising from due diligence of the two banks’ soured and risky loans.

A treasury source said the government estimated that the total 12 billion euros in guarantees would translate into a fair-value exposure of just 400 million euros for the state, but did not explain how it arrived at that figure.

The EU Commission also said in a statement that the “net costs to the Italian state will be much lower than the nominal amounts of the measures provided”. It too did not explain.

Banking analysts, however, said the state could ultimately be on the hook for up to 17 billion euros, even though some value could be salvaged once the soured loans were fully analyzed, limiting the final bill for taxpayers.

‘TOUGH CONDITIONS’

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Intesa Sanpaolo, Italy’s best-capitalized large bank, said last week it was open to purchasing the rump of the good assets for one euro on condition Italy’s government passed a decree agreeing to shoulder the cost of winding down the two banks.

Setting tough conditions for the deal, Intesa CEO Carlo Messina has insisted that his bank’s capital ratios and dividend policy would not be affected by the transaction.

“Without Intesa Sanpaolo’s offer - the only significant one submitted at the auction held by the government - the crisis of the two banks would have had a serious impact on the whole Italian banking system,” Messina said in a statement on Sunday.

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The European Central Bank, which supervises the two lenders based in the country’s rich north-eastern Veneto region, had declared on Friday that they were “failing or likely to fail”, setting in motion the process that led to them being wound down.

After months of tense negotiations between Rome and EU regulators, Italy has been allowed to use national insolvency procedures rather than EU rules designed to prevent the use of state money to deal with bank crises.

Those EU rules could have imposed losses on senior bondholders and large depositors, a politically unpalatable prospect ahead of national elections next year given that Italian households hold a large chunk of bonds issued by banks.

Some European officials have voiced exasperation at the way Italy has dealt with a string of trouble spots in its banking industry, which is weighed down by nearly 350 billion euros of soured debts -- a third of the euro zone’s total.

The country’s fourth-biggest bank, Monte dei Paschi di Siena, is being bailed out by the state to cover a capital shortfall of 8.8 billion euros. Four other smaller banks were wound down in 2015.

The future of the Veneto banks had hung in the balance over the past two years since the ECB uncovered a capital hole caused by a spike in bad loans and a mis-selling scandal whereby the banks’ customers were sold shares in exchange for loans.

The dragged-out negotiations between Rome, Frankfurt and Brussels and their outcome on Sunday have raised serious questions about the effectiveness of banking supervision and the credibility of Europe’s own rules for dealing with bank crises.