The government rescued Monte dei Paschi (MPS) in 2017, paying 5.4 billion euros ($6.3 billion) for a 68% stake now worth 1 billion euros, which it must sell next year under the terms of the 8.2 billion euro bailout.

To boost the appeal of the world's oldest bank still in business, Italy has been working on a scheme to cut MPS' problem loan ratio below the industry average, offloading 8 billion euros in soured debts to state-owned bad loan manager AMCO.

To merge MPS with a rival, however, the state must also provide adequate compensation for billions of euros of legal claims from investors, bankers say, inflating the bill for Italian taxpayers.

"The Treasury has a very narrow path ahead. Exiting MPS at a significant loss would shake the very idea of state intervention in the economy. It'd be hard to justify more equity investments in the near future," said Stefano Caselli, banking and finance professor a Milan's Bocconi University.

To authorise the clean-up, which shaves 1.1 billion euros off MPS' capital and must be completed by Dec. 1, the European Central Bank has demanded MPS raises fresh capital via costly issues of Tier 1 and Tier 2 debt.

MPS paid 8.5% for the Tier 2 issue, and analysts say Additional Tier1 (AT1) debt is a non-starter for a bank that expects to remain loss-making through 2022 and would not be allowed, as such, to pay a coupon on it.

The Treasury planned to sidestep the AT1 issue by clinching a merger deal by Christmas, sources had said, but MPS is proving a tough sell in an industry whose feeble profitability is being hammered by the COVID-19 pandemic.

FEW OPTIONS

The surprise takeover of Italy's healthiest second-tier bank UBI Banca by heavyweight Intesa Sanpaolo this year took two potential candidates off the table, leaving the Treasury few options, according to people familiar with the matter.

MPS has drawn no interest from foreign lenders and the Treasury has been looking at both UniCredit and Banco BPM, respectively Italy's second- and third-largest banks, as potential buyers, the people said.

A person close to the sale process said UniCredit would be best placed to take on MPS given its larger size and robust balance sheet.

But any potential buyer would seek to replicate a deal Intesa secured in 2017 when it bought the healthy assets of two failing regional Italian banks for a token one euro, sources say.

In that sale, AMCO took over 18 billion euros of problem loans and committed to taking on another 4 billion if they turned sour. Intesa got 4.8 billion euros in state cash to fully offset the hit on its regulatory capital and cover restructuring costs.

It also got public guarantees for 1.5 billion euros against future risks and claims.

Analysts calculate restructuring costs alone in an MPS deal at 2 billion-3 billion euros. The Treasury has set aside 1.5 billion euros so far to support MPS.

A government source told Reuters the Treasury wanted to avoid a repeat of the Intesa deal, which met EU state aid rules because the two banks were liquidated under national laws.

UniCredit, however, cannot afford to dent its capital buffers, which CEO Jean Pierre Mustier has worked hard to beef up.

UniCredit has ruled out any mergers and Banco BPM has denied any interest in MPS.

Sources say both may still consider a deal with favourable terms, although Banco BPM may now be headed for merger discussions with France's Credit Agricole.

Caselli at Bocconi University said the Treasury may have to think again about finding a buyer quickly.

"A postponement may currently be the most reasonable solution," he said.

Italy is in talks with the European Commission to revise MPS' restructuring plan and an extension of the 2021 deadline is a possibility.

MPS has been laid low by years of mismanagement, an ill-advised acquisition and risky derivatives deals.

It faces 10 billion euros in legal claims, mostly from disgruntled investors who lost money in a string of cash calls worth 18.5 billion euros in the past decade.

MPS expects part of the claims to be dismissed and has set aside funds that cover only a small fraction of the requests.

The ruling 5-Star Movement has been calling for the state to hold onto MPS and Prime Minister Giuseppe Conte had delayed signing a decree that paves the way for the bad loan spin-off.

Two sources familiar with the matter said a compromise had been found and all the necessary documents would be in place by a shareholders' meeting on Sunday.

By Valentina Za, Pamela Barbaglia and Gianluca Semeraro