Board members at Monte dei Paschi are expected to say on Wednesday that Italy's third largest bank may have lost up to 1 billion euros on opaque derivatives trades, far higher than the initial estimate.
The trades are at the center of a probe into former management of the bank which has deepened questions about the role of banking supervisors and the influence of local politicians ahead of Feb 24-25 parliamentary elections.
A source close to the situation said the final loss, set to be announced after the market close on Wednesday, should be somewhere between the preliminary estimate of around 720 million euros ($974 million) and 1 billion euros.
The findings of a review of the trades and their impact on Monte dei Paschi's accounts by external consultants have been submitted to the bank's board, chaired by former UniCredit chief executive Alessandro Profumo.
He has said the bank was not at risk of collapsing from the deals, which the current management says were partially hidden, and promised total clarity after Wednesday's board meeting.
"Profumo appears to have ruled out any catastrophic impact from the trades," said a Milan-based fund manager. "But this does not change the bank's fundamental weakness."
Il Sole 24 Ore daily reported the bank would reveal losses of 920 million euros from the three derivative trades, plus a further loss of 120 million in "personnel costs".
"The numbers in Il Sole are not correct," said the source close to the situation.
Drag on Revenues
The loss from these trades will likely lead to a restatement of past accounts and increase the overall 2012 losses for the Tuscan lender, which had already posted a net loss of 1.66 billion euros in the first nine months.
In the first nine months of 2012, Monte dei Paschi, hit hard by the euro zone crisis because it has the biggest Italian government bond portfolio relative to assets among Italian banks, reported a 15.6 percent annual fall in customer deposits and securities issued.
The bank also had gross impaired loans worth 28.3 billion euros, representing a higher proportion of total loans than the average for other Italian lenders.
Sources close to the matter have told Reuters the bank, the world's oldest, has been negotiating with Deutsche Bank and Nomura to restructure or close the deals.
One source said the negotiations with Deutsche Bank were going well while those with Nomura were dragging. Deutsche Bank and Nomura declined to comment.
Profumo and Monte dei Paschi Chief Executive Fabrizio Viola, who say they discovered the extent of the derivatives deals in October, are keen to clean up a balance sheet burdened by hedging bets gone wrong.
"They want to pull out this painful bad tooth, which is also a drag on revenues, and then there will be no more skeletons in the closet," the source close to the situation said.
In November, Monte dei Paschi increased its request for state aid by 500 million euros, citing a possible hit from unspecified structured transactions.
It has since said that cash buffer will be enough to cushion any loss from the trades.
However, Standard & Poor's last week cut the bank's rating to "BB" - one notch below junk status - because of concern the short fall might be bigger than anticipated.
Monte dei Paschi can at least take comfort from a fall in the spread between Italian 10-year government bonds and equivalent German Bunds in recent weeks, which is cutting the capital shortfall deriving from a mark-to-market of its huge Italian government bond portfolio.
Mediobanca and Merrill Lynch analysts estimate that shortfall to have narrowed to around 2 billion euros now from more than 3 billion six months ago - although that does not take into account the impact of losses on structured transactions.
Even before the derivatives scandal emerged last month, Monte dei Paschi was being investigated over its costly 2007 acquisition of smaller rival Antonveneta, which stretched its finances months before the collapse of Lehman Brothers.
Reuters reported on Wednesday that it had seen a judicial document showing that Monte dei Paschi lied to the Bank of Italy about the terms of its "FRESH 2008" hybrid instrument, worth around one billion euros, which it used to help fund its purchase of Antonveneta.
The document said Monte dei Paschi's then chief financial officer Marco Morelli had signed an indemnity document in favor of J.P. Morgan which was hidden from the regulator.
J.P. Morgan in 2008 underwrote a 1 billion euro capital increase in Monte dei Paschi, and then structured the Fresh 2008 hybrid instrument, convertible in Monte dei Paschi's shares, and sold it to a number of investors.
J.P. Morgan in Milan declined to comment.
According to the prosecutors' document, Morelli also gave a so-called indemnity side letter to Bank of New York, which acted as an intermediary in the FRESH 2008 deal, "at the time of a meeting of the FRESH investors", which was also hidden from the regulator.
Prosecutors suspect that the indemnity side letter violated requirements set by the Bank of Italy by making the FRESH 2008 work like a bond rather than an hybrid equity instrument.