* Bank's own rescue plan fails
* Retail bond holders offered protection
* Government says bank can now recover
By Giuseppe Fonte and Valentina Za
ROME, Dec 23 (Reuters) - The Italian government approved a decree on Friday to bail out Monte dei Paschi di Siena after the world's oldest bank failed to win investor backing for a desperately needed capital increase.
Looking to end a protracted banking crisis that has gummed up the economy, Prime Minister Paolo Gentiloni said his Cabinet had authorised a 20 billion-euro ($20.9 billion) fund to help lenders in distress - first and foremost Monte dei Paschi.
Within minutes of the late-night Cabinet meeting ending, the country's third largest lender issued a statement saying it would formally request state aid, opening the way for possibly the biggest Italian bank nationalisation in decades.
The government has said its long-awaited salvage operation will work within European Union rules, meaning some Monte dei Paschi bondholders will be forced to accept losses to ensure the taxpayer does not pick up all of the bill.
However, the government and Monte dei Paschi promised protection for around 40,000 retail savers who had bought the bank's junior debt. Many of the high street investors say they were unaware of the risks when they purchased the paper.
"Today marks an important day for Monte dei Paschi, a day that sees it turn a corner and be able to reassure its depositors," said Gentiloni, who only took office last week and has made the bank rescue his first priority.
Monte dei Paschi emerged as the weakest of some 51 European banks subjected to stress tests earlier this year by the European Central Bank. It was given until the end of the year to sort out its problems or face being wound down.
The collapse of Monte dei Paschi would have threatened the savings of thousands of Italians and could have had devastated the wider banking sector, which is saddled with 356 billion euros of bad loans - a third of the euro zone's total.
BOND CONVERSIONS
The Siena-based bank has been laid low by ill-judged acquisitions and mismanagement and has the largest proportion of bad debts among Italian lenders compared to its capital.
It had hoped to raise 5 billion euros from private investors, but confirming an earlier Reuters report, the bank said late on Wednesday that it had failed to secure an anchor investor for its offer of new shares.
The government said full details of the rescue plan have yet to be worked out, but it outlined the contours in a statement.
It said the bank's Tier 1 bonds, which are mostly held by professional investors, would be converted into shares at 75 percent of their nominal value.