Citigroup Inc is in talks to give the U.S. government a larger stake, a person familiar with the matter said, which could provide the government with a far greater say in the affairs of the ailing banking giant.

If the government took a large common equity stake, even if it lacked voting control, the move could be the equivalent of a nationalization. Citigroup shares fell below $2 on Friday as investors feared that soaring losses would result in nationalization, wiping out shareholder equity.

Taxpayers could end up owning as much as 40 percent of New York-based Citigroup's common stock, though executives at the third-largest U.S. bank by assets hope to limit the stake to about 25 percent, The Wall Street Journal said on Monday, citing people familiar with the situation.

Talks could lead to the government converting a substantial portion of its $45 billion in Citigroup preferred shares, equal to a 7.8 percent stake, into common stock, diluting existing shareholders, the newspaper said.

The Obama administration has not indicated whether it supports the plan, though the White House has said Obama favors a privately-held banking system.

It can be taken as a commitment that some banks are too big to fail and the economic consequences too bad to contemplate, said Tony Morriss, senior markets strategist at ANZ Investment Bank, in Sydney.

A larger government stake, however, could fuel speculation that Bank of America Corp and other lenders might need similar agreements. If that happened, shares of other lenders could fall, including relatively healthy ones.

Nationalization is a trap that the U.S. government should avoid, Fox-Pitt Kelton analyst David Trone wrote. If Citi is nationalized, all bank stocks are likely to get crushed in fear.

In premarket trading, Citigroup shares rose 9.2 percent to $2.13, while Bank of America rose 10.8 percent to $4.20. JPMorgan Chase & Co rose 5.3 percent to $20.95, and Wells Fargo & Co rose 8 percent to $11.78. U.S. stock futures rose 1 percent, and U.S. Treasury prices fell.

TREASURY OPEN TO CONVERSION

Vikram Pandit, Citigroup's chief executive, has tried to stabilize the bank by dividing it in two, creating Citicorp to house healthier businesses the bank wants to keep, and Citi Holdings to house businesses it hopes to sell or wind down.

The Citigroup news came as governments worldwide move to prop up ailing banks, and after European Union leaders backed a doubling of funds for the International Monetary Fund to aid bailouts of banking and other industries.

Citigroup in October and November issued $52 billion of preferred shares to the government, of which $45 billion was considered capital and $7 billion a fee for the U.S. agreeing to share losses on $301 billion of troubled assets.

Converting the preferred stock to common stock is one of many options for the government, the person who spoke with Reuters said.

The government in September took a nearly 80 percent stake in American International Group Inc, the big insurer.

U.S. Treasury Department spokesman Isaac Baker declined to comment on Citigroup but said Treasury Secretary Timothy Geithner's bank stabilization plan allows lenders to apply to convert preferred shares into convertible preferred shares and later into common equity to bolster capital.

Citigroup declined to comment on the reported talks with the government, but in an email said its capital base is very strong. It said Tier-1 capital, which measures its ability to cover losses, was 11.9 percent at the end of 2008, twice the required minimum.

On the other hand, Citigroup and many rivals come up short of what analysts prefer in another measure of capital -- the ratio of tangible common equity to tangible assets.

Trone said that even if the government takes a 40 percent stake, Citigroup's tangible common equity ratio would rise only to 2.16 percent, less than half the level analysts like to see.

In the coming weeks, the Treasury Department is expected to subject up to 25 banks to stress tests to decide which need additional capital.

STRESS TESTS AHEAD

Citigroup began raising capital aggressively in late 2007, including from Abu Dhabi Investment Authority, Kuwait Investment Authority and Singapore Investment Corp. Saudi Prince Alwaleed bin Talal, the bank's largest individual shareholder, also boosted his stake.

Singapore declined to comment. The others were not immediately available for comment.

We don't know how much pain for investors government measures will induce, said Dariusz Kowalczyk, chief investment strategist with SJS Markets in Hong Kong. By which I mean, will current holders of bank equity lose everything, or most?

Converting Citigroup preferred shares would add pressure on Bank of America, which also received $45 billion from the government and a loss-sharing pact on $118 billion of assets. About three-fourths of those assets came from the former Merrill Lynch & Co, which Bank of America bought on January 1.

Bank of America spokesman Robert Stickler said the largest U.S. bank is not in, and does not expect to enter, talks about new capital or converting preferred stock to common stock.

We believe that we are in very healthy shape, we have strong capital, we have the strongest liquidity in the industry, we are profitable, and we are lending across business lines, he said.

(Additional reporting by Elinor Comlay in New York and Tony Munroe in Hong Kong; Editing by Ian Geoghegan, Andrew Callus and John Wallace)

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