Italy began winding up two failed regional banks on Sunday, the latest twist in the drive to fix the Italian banking system, which is saddled with bad loans worth about 350 billion euros - a third of the eurozone's total bad debt.

Italy's government is bailing out two banks in the Venice region, in a deal that could cost the state up to 17 billion euros 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.

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 criticise us should say what a better alternative would have been. I can't see it," Economy Minister Pier Carlo 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.

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 analysed, limiting the final bill for taxpayers.

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.