The Treasury wants to have secured a solution to long-running problems at MPS by the end of January, one source told Reuters, and UniCredit's robust balance-sheet had led Rome to identify it as the best option to take on the loss-making bank.

Italy's government had been discussing the terms of a possible deal with Mustier, people familiar with the matter had said, before the French banker's sudden exit - a decision he said was made because the board no longer backed his plans.

Mustier, who opposed mergers and favoured instead returning cash to investors in a bid to lift UniCredit's share price, was open to considering a deal with virtually no impact on the bank's capital ratios, two of the people added.

Agreeing a deal is now more complicated as Mustier plans to step down in April or as soon as his replacement is found.

Investors dumped UniCredit's shares in the wake of Mustier's decision due to uncertainty over strategy at Italy's no.2 bank and concerns that a takeover of MPS, in which Rome owns a 68% stake after a bailout in 2017, had become more likely.

In a bid to reassure investors, UniCredit's board said on Tuesday it would never agree to a deal that hurt the bank's capital position.

MPS expects to breach minimum capital thresholds in the first quarter due to the cost of a bad loan clean-up it just completed and provisions against legal risks.

Meanwhile, the bank's pending lawsuits remain the main hurdle to a deal, people involved in the process have said.

UniCredit directors are worried about worsening its risk profile by taking on MPS, three people familiar with the board's thinking said.

A focus of concerns is a push by the co-ruling 5-Star Movement to cap tax benefits the government is planning to introduce to facilitate mergers.

In an effort to minimise disruption, UniCredit's board and Chairman elect Pier Carlo Padoan, Italy's former economy minister who negotiated the MPS bailout with the EU, are searching for a new CEO with headhunters Spencer Stuart.

Relations between Mustier and the board had soured in recent months, people inside the bank said, and speculation about a possible exit had swirled since he turned down the top job at HSBC earlier this year.

(Additional reporting by Gianluca Semeraro and Andrea Mandala in Milan, Stefano Bernabei in Rome; writing by Valentina Za; Editing by Alexander Smith)

By Pamela Barbaglia, Giuseppe Fonte and Valentina Za