(Adds UBI denial of merger talks with Monte Paschi)

By Pamela Barbaglia

LONDON, Nov 2 (Reuters) - Italy's Banca Monte dei Paschi di Siena is working on a rights issue to fill at least half of a 2.1 billion euro ($2.6 billion) capital hole uncovered in a European financial health check, a source with direct knowledge of the matter said.

The world's oldest surviving bank has hired UBS and Citigroup to assess strategic options after it failed the European Central Bank (ECB) test, designed to test the solidity of the euro zone's financial system.

The options for the Tuscan lender, Italy's third-largest, which raised 5 billion euros as recently as June to strengthen its balance sheet and help pay back state aid, are expected to include further asset sales and potential a merger.

The source told Reuters the plan, which has to be presented to the ECB by Nov. 10, would include a "substantial" capital increase of at least 1 billion euros but gave no precise figure because a decision had not yet been taken.

Banks that underwrote June's capital increase remained interested in backing the new cash call, the source said, adding the advisors were also sounding out potential new investors.

The plan also includes an "M&A event" which was more difficult and there were various options on the table, the source said, adding talks with UBI Banca and other merger candidates were under way.

Combining Monte Paschi with a top Italian bank such as Intesa Sanpaolo might lead to heavy job cuts which is why a regional bank is seen as a preferred option, he added.

A spokesman for UBI said there were no talks whatsoever with Monte Paschi over a possible merger.

Monte Paschi was not immediately available for comment.

The bank's chairman, Alessandro Profumo, told Reuters on Tuesday the lender could ultimately become part of a larger entity though he said there had been no talks with any potential buyers. He also said the bank might seek to delay repaying hundreds of millions of euros in state aid to help shore up its balance sheet.

Monte dei Paschi shares have dropped some 40 percent since the result of the ECB stress tests were announced a week ago, meaning the bank is currently worth less than half its value in early June when it raised 5 billion euros in new capital.

($1 = 0.7985 euro) (Writing by Danilo Masoni, additional reporting by Silvia Aloisi, editing by Silvia Aloisi and John Stonestreet)