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UPDATE 3- Italy opts not to raise incentives for bank mergers, hitting shares

* Proposal had raised chance of UniCredit takeover of Banco BPM

* Rome may re-propose the scheme at a later date, a source says

* Treasury wants draft solution for troubled Monte Paschi by July (Recasts with confirmation and details after news conference)

ROME, May 20 (Reuters) - Italy dropped a mooted measure lifting a cap on tax incentives for bank mergers from a broader economic stimulus package, Economy Minister Daniele Franco said on Thursday, in a move which hit banking shares.

The measure, which had been proposed by the Treasury, had boosted the merger appeal of Banco BPM, Italy’s third-largest bank, fuelling investor bets about a potential takeover by rival UniCredit.

Instead, the decree gives lenders only slightly more time to approve potential deals to benefit from existing incentives.

Speaking at a news conference after the cabinet approved the spending package, Franco said the cap on tax incentives would remain at 2% of the assets of the smaller bank involved in a merger.

Italian banking shares fell on the news, which initially emerged from a draft of the decree. Banco BPM dropped as much as 5% and eventually closed 2.1% lower.

An earlier draft bill seen by Reuters on May 3 raised the cap on incentives to 3%, extended them by six months to June 2022 and gave banks three years, instead of one, to complete the merger.

A government source told Reuters the Treasury could re-propose the measure for approval by the cabinet at a later date.

The 2% incentive applies if merger deals are approved by lenders’ boards of directors by the end of this year. At present shareholder approval is necessary by the Dec. 31 deadline.

The tax incentives were introduced by the previous government to make a takeover of bailed-out Monte dei Paschi (MPS) palatable for UniCredit, which is considering potential M&A opportunities under new CEO Andrea Orcel.

As well as increasing by nearly 50% the tax benefits for UniCredit in an MPS deal, the now dropped proposals also strengthened the case for a UniCredit takeover of Banco BPM - making a mooted three-way merger a less remote possibility, bankers said.

The possibility of a buyout offer by heavyweight UniCredit at a time when merger talks with same-size peer BPER Banca have stalled, had alarmed Banco BPM CEO Giuseppe Castagna, sources close to the matter said.

Castagna travelled to Rome last week after reports about the revised incentives to complain to ruling politicians about their impact on various merger scenarios.

The higher cap would have had no bearing on a potential Banco BPM-BPER tie-up, analysts say, because the banks are a similar size.

Italy is working to meet a mid-2022 deadline to cut its 64% stake in MPS but talks with UniCredit which started under Orcel’s predecessor Jean Pierre Mustier have so far failed to produce results.

Several people close to the matter said the Treasury is now hoping to have at least a draft solution for MPS in hand by July, when banking supervisors will publish the results of stress tests in which Monte dei Paschi is expected to fare poorly.

MPS, whose restructuring has been thrown off track by low rates and the pandemic, needs more capital five years after an 8 billion euro ($9.77 billion) rescue which cost Italian taxpayers 5.4 billion euros.

The bank this month narrowed the size of its capital gap to below 1 billion euros, but said it was still keeping a proposed capital raising at 2.5 billion euros pending the stress tests’ results.

$1 = 0.8188 euros Reporting by Giuseppe Fonte, Valentina Za and Andrea Mandala, editing by Gavin Jones, Kirsten Donovan

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