NEW YORK (Reuters) - Citigroup Inc is in talks to give the U.S. government a larger stake, a person familiar with the matter said, providing Washington with a far greater say in the affairs of the ailing banking giant.

Taxpayers could end up owning as much as 40 percent of 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.

The 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 government took that stake when it bailed out the bank last fall.

"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.

Citigroup shares rose 33 cents, or 16.9 percent, to $2.28 in early trading after U.S. bank regulators said they stood ready to provide more capital to the banking sector and "preserve the viability of systemically important financial institutions."

If the government took a large common equity stake in Citigroup, the move would stop short of a full nationalization that wipes out shareholder equity. But such a move could be the functional equivalent of nationalization, even if the government lacked voting control.

"The government doesn't want to do this," said Art Hogan, chief market analyst at Jefferies & Co in Boston. "This is government looking into Citigroup, saying what is the best way to keep the banks alive, not the stocks alive. That's the important part."

The White House has said President Barack Obama favors a privately-held banking system.

Moreover, 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, a spokesman said.

NATIONALIZATION TRAP

In the coming weeks, the Treasury Department is expected to subject banks with more than $100 billion of assets to "stress tests" to decide which need capital. Citigroup ended 2008 with $1.95 trillion of assets.

Governments worldwide are moving to prop up ailing banks. Britain, for example, has taken a majority stake in Royal Bank of Scotland Group Plc.

A larger government stake in New York-based Citigroup 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 early trading, Bank of America rose 14.5 percent to $4.34, JPMorgan Chase & Co rose 6.4 percent to $21.18, and Wells Fargo & Co rose 6.8 percent to $11.65. The Standard & Poor's 500 rose 1 percent, and U.S. Treasury prices fell.

STRESS TESTS AHEAD

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 bank has lost $28.5 billion in the 15 months ended December 31, 2008, and analysts expect losses in 2009 and 2010.

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.

Citigroup declined to comment on the reported talks with the government, but in an email said its capital base is very strong, with Tier-1 capital, which measures its ability to cover losses, about 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.

If the government converted $45 billion of preferred shares into common stock, Citigroup's tangible common equity ratio would rise to about 3.9 percent of tangible assets from its current 1.5 percent. Tangible common equity is a measure of how much common equity a bank has to cushion itself through difficult times, when intangible assets like goodwill may have to be written down.

There is no market consensus regarding how much tangible common equity a bank should have. Some investors believe it should be more than 5 percent, while other believe it should be more than 7 percent. But there is wide consensus that current levels at major banks are too low, signaling that banks don't have enough resources to carry themselves through difficult times.

BIG INVESTORS

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.

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 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.