* Moody's cuts Monte Paschi to Ba2, outlook negative
* Bank already requested 1.5 bln euros in fresh state aid
* Moody's says bank turnaround plan has execution risks
* Shares down 4.5 pct vs flat European banking index
By Silvia Aloisi and Stefano Bernabei
MILAN, Oct 18 (Reuters) - Moody's cut the rating of Italy's third largest lender, Banca Monte dei Paschi di Siena, to junk and said it may need more state aid, triggering a 6 percent selloff in the bank's shares on Thursday.
Monte Paschi, the world's oldest surviving bank, was the only Italian lender to fail the European Banking Authority's stress tests and is the first of the five systemically important Italian banks to fall below investment grade.
Moody's said the bank's outlook remained negative, keeping pressure on the Tuscan lender as it tries to navigate a deep recession and the euro zone debt crisis.
The downgrade from Baa3 to Ba2 means some investment funds that hold Monte Paschi bonds will be forced to sell them, making it even harder for the bank to raise funds.
"Investors have been on red alert on Monte Paschi since it failed to meet the EBA stress test. They now fear the other three rating agencies monitored by the ECB (European Central Bank) would follow through," said a banker at a lead manager for syndicated bonds.
"The bank will have even more difficulties with funding going ahead."
For shares, the overall impact was more limited, as many investors had already offloaded Monte Paschi stock.
"Unless there's the express request from the investor we can't buy junk status bonds. And if we have them in our portfolio we have to sell," said Roberto Lottici, fund manager at Ifigest. "For shares, there will be a discussion in the investment committee."
Moody's rates Italy's sovereign debt Baa2, three notches above Monte Paschi.
The spread over midswap of Monte Paschi's bond maturing 2015 widened to 25 basis points to 500 bps after Moody's move.
The Siena-based bank, which was already exchanging money for Tuscan and foreign merchants before Christopher Columbus discovered the Americas, requested 1.5 billion euros in state loans in June to plug a capital shortfall under a scheme that is still awaiting EU approval.
The bank had already received state help in 2009 in the form of special bonds worth 1.9 billion eurosold to the Treasury.
The bank has also won shareholder backing for a 1 billion euro capital increase to be launched by 2015.
However, Moody's said overnight there was a "material probability that the bank will need to seek further external support." This would probably be more government help, Moody's said, without saying how much would be needed.
It cited Monte Paschi's weak asset quality, which it said would continue to deteriorate due to Italy's recession, and said problem loans had risen to 17 percent of its loan book - above the 13 percent average of Italian banks rated by the agency.
"Monte Paschi's weak profitability and fragile asset quality exacerbate its weak funding position, leaving it unable to access capital markets and in consequence making Monte Paschi highly reliant on the European Central Bank," Moody's said.
Monte Paschi's fundamental weakness stems from its above average holdings of Italian state bonds relative to assets, which like peers it had to mark down as the euro zone crisis hurt the value of sovereign debt in Italy and elsewhere.
Adding to the bank's woes was Monte Paschi's decision to pay 9 billion euros in cash for the acquisition of smaller peer Antonveneta in 2007, which used up cash just as the global financial crisis exploded.
The bank's main shareholder, a cash-strapped foundation with strong political links to the city of Siena, took on big debts to keep a grip on the bank, only to be forced to sell down its stake in a downward market when time ran out.
Monte Paschi, which held 25 billion euros in Italian debt at the end of June, took 30 billion euros of cheap three-year ECB loans in two round of auctions in December and February.
Yet, Chairman Alessandro Profumo has already said Italian banks may need to roll over the cheap ECB funds to avoid a credit crunch in two years' time.
Profumo, formerly at the helm of Italy's biggest bank by asset UniCredit, was hired by Monte Paschi to help Chief Executive Fabrizio Viola spearhead a turnaround.
Investors have welcomed Monte Paschi's tough business plan, which envisages 4,600 job cuts and the slashing of its loan book. Yet, Moody's said the restructuring was "subject to significant execution risk."
Monte Paschi's shares were down 4 percent at 0.24 euros by 0922 GMT, the worst-performing stock of a flat European banking index.