By Francesca Landini and Stephen Jewkes
MILAN (Reuters) - Monte dei Paschi di Siena <BMPS.MI> may convert the bulk of its subordinated debt into equity to cut back a planned five billion euro ($5.6 billion) capital increase and make it more attractive for investors, three sources said on Tuesday.
Italy's third largest bank announced the share sale in July as part of a wider bailout plan to prevent it being wound down.
But the troubled lender, which emerged as Europe's weakest bank in stress tests last month, faces an uphill task convincing investors to buy into such a big share issue -- its third recapitalization in as many years.
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Monte dei Paschi's cash call comes as investors grow increasingly concerned over the outcome of a constitutional referendum Italian Prime Minister Matteo Renzi has bet his political career on.
The rescue rights issue is part of a two-pronged plan for the world's oldest lender, including the sale of 9.2 billion euros of non-performing loans to clean up its balance sheet.
"The idea is to reduce the size of the capital hike to around 3 billion euros," one of the sources said.
A second source said cutting the size of the cash call to 3 billion euros would be a best-case scenario, implying the bank could raise 2 billion euros from the bond conversion.
The Tuscan bank's board met on Monday for an update on its restructuring plan, but made no decision on converting debt.
Monte dei Paschi declined to comment.
The bank's CEO Fabrizio Viola said in July it would be looking at ways to reduce the size of the capital increase.
Bankers have said a bond-to-equity conversion would be the most obvious choice.
The bank is being advised by JPMorgan <JPM.N> and Mediobanca <MDBI.MI> who are also global coordinators for the share sale, which must be completed by year end.
One of the sources said the bond conversion, if it went ahead, would be voluntary.
"The bank is considering whether the bond-to-equity conversion should be offered to institutional investors only or also to retail," the source said.
The source said just over 4 billion euros of Monte dei Paschi's outstanding subordinated debt, out of a total of just over 5 billion euros, can be targeted for the conversion.
The fund raising also risks coming just before a bumper capital increase by Italy's biggest bank UniCredit <CRDI.MI> which sources have said could be as much as 8 billion euros.
Because of the sheer size of Monte dei Paschi's capital increase, which compares to a market capitalization of just 704 million euros, the bank's advisers are looking for "anchor investors", including funds, to commit to the deal to bolster sentiment, one of the sources said.
($1 = 0.8966 euros)
(Editing by Silvia Aloisi and Alexander Smith)