The Tuscan bank, which has one of the heaviest bad loan burdens in Italy, is likely to be found short of capital under an adverse scenario in European Union (EU) stress tests results due to be released on Friday.

In a bid to reassure the market, Italy is looking for ways to support its banks without breaking EU state aid rules that would require investors to take a hit first

AdEPP, the association of sector-specific pension funds, said on Monday a decision had been taken to support a new bank fund called Atlante 2, but added each pension fund would then need to approve the investment.

AdEPP chairman told Reuters the government had asked its members to invest in Atlante, which is working with Monte dei Paschi on the sale of bad debts worth a net 10 billion euros ($11 billion).

A source familiar with the matter said Rome had asked for a 500 million euro investment.

Atlante, hastily set up in recent months to help Italy's weakest banks, has used more than half of its initial 4.25 billion euro endowment to take over two failing regional banks.

The source said the new fund would only invest in bad loans and not bank equity.

Bad debts totalling 360 billion euros have become the focus of investor concerns over Italian banks, weighing heavily on their shares.

Sources have said Italian state lender Cassa Depositi e Prestiti (CDP) is also ready to provide up to 500 million euros to the new Atlante fund. A similar amount would come from SGA, another Treasury-controlled entity.

AID RULES

To comply with a request from European Central Bank supervisors to clean up its balance sheet, Monte dei Paschi last week submitted to the ECB a plan to sell its bad loans and is hoping for a green light by Friday.

Under the plan, Atlante would buy the bank's loans to borrowers deemed insolvent in a complex scheme that aims to leverage fivefold the fund's residual resources of 1.75 billion euros, sources have said.

Atlante is ready to buy the loans at a higher price than investors specialising in distressed assets would offer, but that would still be below the portfolio's net book value, blowing a hole in the bank's account and forcing it to raise capital.

The worry is Monte dei Paschi would struggle to find the money at a time when sector profits are being squeezed by negative interest rates and poor asset quality.

EU state-aid rules have hampered Italy's efforts to backstop Monte dei Paschi's capital raising.

A source with knowledge of talks between Italy and the European Commission on state support for weak Italian lenders said Rome now saw the possibility of state intervention as a last resort.

"A precautionary capital increase (for Monte dei Paschi) funded by the government is only a contingency plan ... Rome is doing everything it can to avoid tapping public money," the source said.

Monte dei Paschi shares, which have lost 76 percent this year, ended down 8.4 percent. ($1 = 0.9107 euros)

(Editing by Susan Fenton and Alexander Smith)

By Stefano Bernabei and Francesca Landini