Citigroup is in talks that could result in the U.S. government increasing its stake in what was the country's most valuable bank, a source said, and the Wall Street Journal said taxpayers could own as much as 40 percent of the ailing lender's common stock.

But the Journal, citing sources familiar with the talks, said Citigroup executives hope discussions with U.S. officials will result in a government stake closer to 25 percent.

The administration of President Barack Obama has not indicated whether it supports the plan, the report said.

A source familiar with the situation told Reuters that talks were ongoing between Citi and regulators that could increase the government's stake.

Citi is discussing with U.S. officials a scenario under which a substantial portion of the $45 billion in preferred shares held by the U.S. government, amounting to a 7.8 percent stake in Citigroup, would convert into common stock, the Journal reported.

The plan would not cost further taxpayer money, but other Citi shareholders would see their stakes diluted and the government would have much larger influence over Citi.

The New York Times reported on its website that the plan being contemplated at Citi could pave the way for similar moves at other big banks.

Separately, the Financial Times said Citigroup was pressing the U.S. government to agree on a new capital injection that would increase the authorities' stake in the bank to about 40 percent, but stop short of outright nationalization.

U.S. stock futures rose 1.2 percent, and Treasuries fell, after the reports on Monday.

It's a sign of relief that the move at least removes some of the uncertainty around the banking sector, said Tony Morriss, senior markets strategist at ANZ Investment Bank, in Sydney.

They are certainly moving much faster this time and it can be taken as a commitment that some banks are too big to fail and the economic consequences too bad to contemplate.

Shares in Citigroup and Bank of America tumbled for a sixth straight session on Friday amid fears the government could nationalize the two banks, wiping out shareholders' investments.

TREASURY OPEN TO CONVERSION

Citigroup in October and November issued a total of $52 billion of preferred shares to the government, $45 billion of which was considered capital and $7 billion was considered a fee for the U.S. agreeing to insure a portfolio of Citigroup assets.

The government in those deals also received warrants to buy 7.8 percent of the bank's shares.

The source who spoke to Reuters also said one possibility could be the conversion of preferred stock to common shares, but stressed there were many other possibilities.

The discussions reflect growing concerns that Citi and other big U.S. banks could be swamped by losses amid the housing crisis and swooning economy, the Journal said.

The U.S. Treasury declined to comment on the reports, but said it was open to converting preferred shares into common equity to strengthen banks.

Spokesman Isaac Baker said that, under Treasury Secretary Timothy Geithner's bank stabilization plan, institutions can apply to convert preferred shares into convertible preferred shares and later into common equity as needed to strengthen their capital structure.

We are open to considering a request to do so if the institution and its regulator believe it would promote the long term stability of that institution, and if we believe it's in the best interest of long term stability of our economy and financial system, Baker said in a statement.

The White House later said President Obama favors a privately held banking system.

Citi declined comment on the reports, but said in an emailed statement: Citi's capital base is very strong and our Tier-1 capital ratio as measured at the end of the fourth quarter was 11.9 percent, among the highest in the industry.

We continue to focus and make progress on reducing the assets on our balance sheet, reducing expenses and streamlining our business for future profitable growth.

STRESS TESTS AHEAD

In coming weeks, the Treasury is expected to subject up to 25 banks, each with assets exceeding $100 billion, to stress tests to decide which need additional capital.

Citigroup officials hope to persuade private investors that have bought preferred shares -- including the Government of Singapore Investment Corp (GIC), Abu Dhabi Investment Authority and Kuwait Investment Authority -- to also convert their preferred shares into common stock, the Journal reported.

Until most of the news is known, there will be a lot of volatility and probably a downward trend in the equity market because 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?

The Financial Times said Citi insiders expect a decision on the company's future in the coming weeks, but warned it would have to come earlier if its shares fell again this week.

Citi could also try to raise fresh equity with a public share offering, the FT said. The aim would be to keep the government stake to no more than 40 percent, or at least below 50 percent, it said, citing people familiar with the plan.

Citi stock has dropped 71 percent so far in 2009.

(Editing by Ian Geoghegan and Jean Yoon)

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