By Danilo Masoni
MILAN (Reuters) - European shares rose on Monday to their highest level since late October, shrugging off worries over political instability in Italy, with the broader market underpinned by gains in banks as investors sought to snap up bargains in the battered sector.
The pan-European STOXX 600 <.STOXX> index was up 1.3 percent in morning trade, reversing initial losses, with the banking sector <.SX7P> providing the biggest lift in terms of index points, even though trading was volatile.
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Italy's banking index <.FTIT8300> fell as much as 4 percent in early deals on worries that efforts to clean up bad debts and raise capital could be derailed by renewed political uncertainty. The index, which has lost about half of its value this year, briefly turned positive and was last down 0.7 percent. Europe's bank index <.SX7P> rose 1.2 percent.
Italian Prime Minister Matteo Renzi said he would resign after suffering a crushing defeat on Sunday in a referendum on constitutional reform, raising worries of early elections in 2017 and a possible failure of lender Monte Paschi's recapitalization plan.
But traders said shares changed direction as short covering kicked in, with investors attracted by low valuations and reassured by expectations the European Central Bank (ECB) would step in if needed.
"It's clearly tempting to buy back Italian shares on the dips especially if one bears in mind (ECB chief Mario) Draghi's 'whatever it takes' stance," said Stephane Ekolo, chief European strategist at Market Securities.
Some investors also said they did not expect early elections in Italy, giving time to solve its bank problems.
"We'll probably see .. a technocratic government to rule until the next general election in 2018. Italy, the EU and the ECB may also need to help the Italian banking sector with their ongoing recapitalization efforts," Columbia Threadneedle fund managers Philip Dicken and Adrian Hilton said in a note.
ECB Governing Council member Ewald Nowotny said market concerns about Italy's financial sector should be kept in perspective and any problems there were manageable. The central bank holds a policy meeting on Thursday.
Monte Paschi was flat after opening sharply lower. Morgan Stanley said it saw state-aid for the troubled lender as increasingly likely, adding the referendum's outcome made it more difficult for the bank to find an anchor investor.
The mining sector index <.SXPP> was up 1.6 percent, helped by rising copper prices, while auto stocks <.SXAP> rose 2.5 percent as the export-oriented sector was helped by a weaker euro.
Luxury goods groups were also in demand, helped by upbeat broker comments. Burberry <BRBY.L> rose 2.6 percent after the Financial Times said the company had rejected multiple takeover approaches from U.S. fashion accessories group Coach <COH.N>.
(Additional reporting by Maria Pia Quaglia; Editing by Mark Potter)