ECB supervisors have told the Tuscan bank to cut its non-performing loans by 9.6 billion euros (£8 billion) over the next two and a half years, a much faster pace of reduction than envisaged in the bank's current strategic plan.

Monte dei Paschi is expected to fare poorly in European banking stress tests whose results will be unveiled on July 29.

By that date it wants to have a plan to sell its bad debts and cover the ensuing capital shortfall to cushion any potential negative market reaction. The stock has already lost 74 percent this year against a 50 percent drop for the sector in Italy.

A source familiar with the matter said the bank had submitted to the ECB a plan that envisaged quickly selling its entire portfolio of loans to borrowers deemed insolvent.

Those loans are currently valued in the bank's books at 37 percent of their face value, or 10 billion euros.

The source said they could be sold at between 33 and 27 percent of their nominal value -- translating into a loss of between 1 billion and 2.7 billion euros.

The ECB and Monte dei Paschi declined to comment.

To fill the capital shortfall, the plan includes a cash call that could be underwritten either by a consortium of banks that is still in the making or by the Italian state if this was allowed by European authorities, the source said.

Italy is in talks with Brussels over ways to support its struggling lenders without breaching EU rules that aim to limit state aid to banks. The rules would require inflicting losses on investors in the banks as a precondition of any state support.

Monte dei Paschi, whose balance sheet has been wrecked by a costly acquisition and risky derivatives deals, has long been seen as the weak link in Italy's troubled banking system.

A harsh recession has saddled Italian banks with 360 billion euros in non-performing loans, compounding the challenge posed by negative interest rates that erode margins.

In an effort to help its banks, Italy has sponsored the creation of a privately financed rescue fund, Atlante, and set up a guarantee scheme for banks looking to sell bad loans.

Atlante is in talks with Monte dei Paschi to buy its bad debts, sources have said.

The fund has just 1.75 billion euros left after investing in the recent rescue of two regional banks. It has failed so far to raise more cash after Italian banks and insurers provided it with 4.25 billion euros in April.

(Additional reporting by Stefano Bernabei; Editing by Mark Bendeich)

By Paola Arosio and John O'Donnell