The bank, the country's third largest, must find an extra 2.5 billion euro ($3.3 billion) to shore up its finances, the government said late on Sunday, highlighting its continuing weakness after a huge derivatives scandal surfaced this year.
The difficulties faced by Monte dei Paschi, which has strong local political and business links, are a microcosm of wider problems in Italy, where a tax fraud case against former Prime Minister Silvio Berlusconi could bring down the government.
If the lender fails to raise enough funds, state aid given to the bank earlier this year would have to be converted into shares in the bank, EU Competition Commissioner Joaquin Almunia said after meeting Italy's economy minister on Saturday.
The European Commission, under pressure to prevent taxpayers footing the bill for bank bailouts, demanded the tougher restructuring plan as a condition for its approval of the 4.1 billion euros Monte dei Paschi got from the state this year.
The capital increase, to be carried out in 2014, was previously expected to amount to 1 billion euros, while the new figure matches the lender's current market capitalisation.
The world's oldest bank said on Monday it expected to approve the new plan - the latest measure in a painful recovery process for the 540-year-old Tuscan lender - on Sept. 24.
Along with the derivatives scandal, Monte dei Paschi is at the centre of a judicial probe over its expensive acquisition of rival Antonveneta in 2008.
Known as "Daddy Monte" in Siena where it is the biggest private employer, the bank sits at the heart of local control and political patronage.
"There's no chance on the planet that they can raise 2.5 billion euros on the market within 12 months. They are heading towards nationalisation," Giuseppe Bivona, a former Goldman Sachs and Morgan Stanley investment banker who has been advising consumer group Codacons in a series of lawsuits against Monte Paschi, told Reuters.
The stock, which was worth 3 euros at the time of the ill-fated Antonveneta buy and has lost 60 percent of its value since the euro zone crisis began hitting Italian lenders two years ago, fell 3 percent to 0.21 euro on Monday.
"I don't see how the market could take the news well today. It will be difficult to find someone to shell out all that money," a Milan trader said.
Monte dei Paschi's biggest shareholder is a cash-strapped foundation, a charitable entity with close ties to local politicians in Siena, home to the bank's ornate headquarters, and the surrounding Tuscany region.
The foundation has had to cut its stake inthe bank to 33.5 percent to pay back huge debts it had taken on to keep its grip on the lender, and is looking to further reduce its holding.
It has already ruled out taking part in any new capital increase, and the bank's management has repeatedly said no new potential investors have materialised so far.
Some analysts said Monte Paschi's best option to avoid nationalisation could be a debt-to-equity swap, converting subordinated bonds it has already issued into shares. Monte dei Paschi has 5.4 billion euros of such oustanding debt, according to a financial source.
"That would be a hit for bond holders and also for shareholders, but at least it would be fairer on taxpayers and it would be in line with the new bail-in guidelines for banks," said Fabrizio Bernardi, analyst at Fidentiis.
The biggest outstanding subordinated bond - for about 2 billion euros and expiring in 2018 - was sold to retail investors to help fund the Antonveneta buy.
Job cuts, branch closures
With investors wary about potential problems at the bank, which has announced thousands of job cuts and closed hundreds of branches, it may be hard to attract private money, raising a serious problem for Prime Minister Enrico Letta.
Italy, struggling to control its 2 trillion euro public debt and looking to boost revenues through privatisations, can ill-afford to take on additional burdens as a shareholder. But it may end up with little choice.
Italy has so far managed to avoid nationalising any of its banks in the wake of the financial crisis but it has faced heavy pressure from organisations including the International Monetary Fund to strengthen its banking system.
As well as the capital hike, the Monte dei Paschi plan also includes new cost cuts and a gradual reduction in the bank's huge government bond portfolio which totalled 29 billion euros at the end of June, although the economy ministry said it would not affect its role as a market operator.
The ministry said it expected the EU approvals process could be completed within two months.
($1 = 0.7600 euros) (Additional reporting by Valentina Za, Lisa Jucca, Stephen Jewkes and Isla Binnie; editing by Philippa Fletcher)