The reform of Bankia, saddled with huge toxic loans which put it at the heart of Spain's banking crisis, will include cash injections and a management shakeout, a government source and another source said. The lender is run by Rodrigo Rato, a former minister for the ruling centre-right People's Party.

However the sources declined to confirm reports Bankia - an agglomeration of local banks or "cajas" - would need as much as 10 billion euros ($13 billion) in capital, and it was not clear how the government, struggling to reduce its deficit, will raise the money.

Spanish Prime Minister Mariano Rajoy said on Monday his government will detail a fresh banking system reform on Friday, saying he would use state money to help lenders, but only as a last resort. He said the plan would not affect the public deficit.

"The plan is being finalized by the Economy Ministry and the Bank of Spain. It will include major changes in the management," one of the sources said.

The Bankia rescue will dovetail with a wider plan to create a so-called bad bank to park and eventually sell off toxic real estate assets held by the banks.

The clean-up of Bankia's balance sheet, which holds around 10 percent of domestic deposits and is highly exposed to the collapsed property sector, would involve billions of euros in a state-backed loan at a rate near 8 percent, El Pais said.

The Bank of Spain and Bankia declined to comment.

Bankia's shares fell 3.3 percent to 2.373 euros shortly after they opened. Spain's country risk, as measured by the spread between yields on Spanish and German benchmark bonds, spiked up to about 429 basis points before coming back to 427 bp.

POTENTIAL COST

The euro zone's fourth-largest economy is widely considered the next weak link in the bloc's debt crisis after the rescue of Portugal, Greece and Ireland, and Bankia is at the core of market concerns over the potential cost of a Spanish bank bailout.

The government has passed austerity measures worth more than 40 billion euros ($52.5 billion) for this year, in an effort to reduce a public deficit of 8.5 percent of gross domestic product last year to 5.3 percent of GDP by the end of 2012.

The government has already spent 18 billion euros to clean up the country's financial sector, has forced the banks into dozens of mergers (including those which created Bankia) and to recognize more than 50 billion euros of losses on property loans and assets.

"If it were necessary to get the credit to save the Spanish financial system I would not hold back from doing what other European Union countries have done, loan them public money, but it would only be as a last resort," Rajoy said on Onda Cero radio in an interview on Monday.

Rajoy's first banks reform, announced in February, has failed to convince markets that the banks have recognized sufficient losses after the bursting of a 10-year real estate bubble.

Spain's banks recently presented plans to the Bank of Spain on how they would raise capital and increase provisioning against potential bad loans.

Bankia told the central bank it can meet requirements for provisions against real estate losses without public money or merging with another entity, sticking with its standalone strategy.

But investors have doubts about whether the strategy will work, doubts which were heightened after Bankia released 2011 accounts last week without being audited.

"Bankia is under pressure to present a recapitalization plan with disposals, and the fact that it hasn't published its 2011 audited accounts isn't helping the situation," Madrid brokerage Renta4 said in a note to clients.

El Pais said the government would refinance Bankia through a hybrid form of debt known as contingent capital, which converts to equity in times of stress.

Bankia and its parent company Banco Financiero y de Ahorros (BFA) could need between 5 billion euros and 10 billion, the paper said.

(Additional reporting by Julien Toyer, Jesus Aguado, Blanca Rodriguez and Robert Hetz; Editing by Dan Lalor and David Holmes)

• A Permanent Economic Emergency