* Rights issue to repay state aid, bolster finances
* Issue at a 35.5 percent discount to the TERP
* Rights fall as much as 10 percent
(Adds shares, rights, interest payment, banker)
MILAN, June 9 (Reuters) - Bailed-out Italian bank Monte dei Paschi di Siena launched a 5 billion euro ($6.9 billion) share sale on Monday, seeking to repay state aid and bolster its finances in preparation for a pan-European review of banks.
The share issue is one of nine capital increases already completed or due to be launched this year by Italian banks after the country's longest recession since World War II.
Monte dei Paschi, whose fundraising comes as Germany's Deutsche Bank is raising 8.5 billion euros, had originally planned to tap investors for 3 billion euros.
But soaring bad loans at the bank led it to increase the issue to 5 billion euros, nearly twice its market capitalisation.
Italy's third-biggest lender, the world's oldest bank still in business, needs the cash to partly repay 4.1 billion euros of state aid it was forced to take last year after being hit by the euro zone debt crisis and loss-making derivative trades.
Reimbursing the bailout is a key condition for avoiding nationalisation. On Monday, the bank said the treasury had agreed to let it defer interest rate payments on the state loans by a month, so it could pay those in cash rather than shares.
The money from the cash call will also be used to cover risks stemming from its loan portfolio, which has the highest proportion of non-performing loans among Italy's largest banks.
A senior banker close to the consortium of underwriters led by UBS said investors' mood towards Italian banks was positive and he expected the share sale to go smoothly.
"The main catalyst for investors is Italy's recovery, because Monte Paschi is one of the best levered plays on an economic pickup. The valuation today is still relatively cheap, it has still some catching up to do with other Italian and European banks," he said.
"There is also an M&A (mergers and acquisitions) angle. It's early days but maybe in 2015, after the asset review, Monte dei Paschi could be player," he added, referring to speculation that Monte dei Paschi could be a takeover target.
Monte dei Paschi said last week, however, that the money raised might not be enough if EU regulators undertaking an industry review force it to set aside more cash to cover for bad loans.
The Tuscan bank is offering offer 214 new shares for every five held, at a price of 1 euro each.
That implies a 35.5 percent discount to the theoretical ex-rights share price (TERP), which takes account of the dilutive effect of the new shares, and a 96 percent discount to the previous closing market price of around 24 euros.
In contrast, Deutsche Bank offered a discount of around 21 percent to the TERP on the first 6.75-billion-euro part of its rights issue.
Traders said the discount at Monte dei Paschi was meant to protect the issue's underwriters - a consortium of 23 banks - from the risk of a large amount of unsold shares, given the sheer size of the issue.
On Monday, the rights of existing investors to take part in the share issue fell as much as 10 percent and were last trading down 5 percent at 21.9 euros, reflecting some shareholders' decision not to take part in the offering.
Monte dei Paschi shares failed to trade, but were indicated higher, signalling some confidence the issue will get done.
The transaction will cost the bank 260 million euros.
(Additional reporting by Lisa Jucca and Valentina Za; Editing by Jason Neely and Mark Potter)