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* Three-way deal with UBI, BPM would create national champion

* Economy minister met CEOs of UBI, BPM on Wednesday

MILAN, Jan 27 Italian authorities seeking to strengthen Monte dei Paschi di Siena are exploring a merger with UBI and Banca Popolare di Milano to create a national banking champion, sources close to the matter said.

Such a deal would accelerate Rome's push for consolidation of Italy's banks, although it would be tricky to pull off as Popolare di Milano (BPM) is already in the advanced stages of merger talks with Banco Popolare, the sources said.

As well as helping Rome deliver on its promises to overhaul Italy's banking system, it would ensure Monte dei Paschi stays in Italian hands, a scenario favoured by Prime Minister Matteo Renzi.

Renzi's government is "definitely exploring" the three-way option, a senior banking source said.

A merger with BPM remained UBI's preferred option, a second source said, although the idea of a three-way tie up involving Monte dei Paschi - in which the Italian Treasury holds a four percent stake and which has been told by the European Central Bank to find a buyer - was gaining traction.

Shares in the Tuscan bank, seen as Italy's most vulnerable because it has the highest level of bad loans as a proportion of assets, have fallen by 44 percent since the beginning of the year. This drop has worried Italian authorities, bankers say.

Economy Minister Pier Carlo Padoan met the chief executives of UBI and Popolare di Milano on Wednesday to discuss the prospects of the banking sector, a Treasury source said.

The source declined to say whether the possibility of a deal between the two banks and Monte dei Paschi was discussed, while the banks declined to comment on the meeting.

A government spokesman declined to comment on the three-way merger plan, as did the three banks involved.

A merger of the three would create Italy's third biggest bank with some 330 billion euros in assets and a strong retail presence in Italy's rich north and centre.

The challenge was made clear on Monday when the CEO of Popolare di Milano, Giuseppe Castagna, said he had never spoken about a three-way merger and there were only two options for his bank - a deal with Banco Popolare or with UBI.

BAD LOANS LINGER

Italian bank stocks have fallen 21 percent since the beginning of 2016 as investors, already rattled about global economic growth, sold out of a sector with low profitability and about 200 billion euros ($218 billion) of bad loans.

The sell-off, which hit Monte dei Paschi the hardest, prompted Renzi to say consolidation could wait no longer.

Renzi's cabinet passed a reform last year forcing the country's 10 biggest cooperative banks to turn into joint-stock companies by the end of 2016, a move aimed at reducing the number of lenders in Italy and making them more efficient.

After months of talks, BPM is working on a deal with Banco Popolare that is seen as a "merger of equals". But bankers say UBI has not lost hope of wooing the mid-sized Milanese bank.

They say personal rivalries and competing regional loyalties play a crucial role in the negotiations, with haggling about the location of headquarters and the distribution of board seats often overshadowing financial details.

But Monte dei Paschi's precipitous share price fall has added urgency to the talks, raising fears the Tuscan bank may fall prey to foreign banks - although Spain's Santander and France's BNP Paribas have denied interest.

A deal Rome struck with the European Commission on Tuesday on a plan to help banks offload soured debts is also seen helping mergers, even though it could expose capital shortfalls.

"Consolidation is a way to offset capital needs," said one banker close to the situation. "No one will buy Monte dei Paschi until they know what the bottom line is for loan loss charges."