Loans by Italian banks to businesses in August posted the biggest drop on record, data showed on Tuesday, indicating the European Central Bank's policy tightening was biting.

A string of hikes by the ECB, whose key rate stands at a record high of 4% since last month, make it much more expensive for firms to borrow.

"The transmission of monetary policy is in full swing," Luca Mezzomo, head of macroeconomic analysis at Italian bank Intesa Sanpaolo's research department, said.

"However, the depth of the contraction has been larger than forecast, and the adjustment of credit conditions swift," he added.

Domestic lenders' credit to businesses fell 6.2% year-on-year in August, the biggest fall on record according to Reuters calculations based on Bank of Italy data, following a 4.0% drop in July.

Mezzomo forecast the credit tightening would reach its peak between late 2023 and early 2024, with the impact of higher rates deepening in coming months even assuming the ECB does not raise them further.

Also in August, data showed residents' deposits with domestic banks continued to fall, though more slowly.

Deposits decreased 5.4% annually after a 6.5% fall in July to stand at 2.42 trillion euros ($2.57 trillion), down from 2.43 trillion in July.

Banks further increased bond issuance to make up for the drop in customer funding, with bond sales up 18.3% in August from a year earlier, after a 17.4% rise in July.

Targeting small savers and diverting cash away from current accounts, Italy's Treasury sold last week more than 18 billion euros of a new BTP bond reserved for retail investors. ($1 = 0.9432 euros) (Reporting by Sara Rossi, editing by Valentina Za and Tomasz Janowski)