UPDATE 3-Italy bank stocks plunge, brokers say tough 2016 ahead

* Italy banking stocks down 17 pct so far this year

* Monte dei Paschi falls 15 pct, junior bonds also suffer

* Monte Paschi is sound, share fall unwarranted - CEO

* Bad loans, margin pressure may weigh as M&A upside fades (Adds Monte dei Paschi CEO comment, updates prices)

By Danilo Masoni

MILAN, Jan 18 (Reuters) - Shares in Italy’s leading banks plummeted on Monday, bringing their losses to 17 percent for the year so far, with brokers warning the negative tone is set to continue after a stellar performance in 2015.

Investors are nervous about how the sector will cope with lower interest rates and a 200 billion euro ($218 billion) pile of loans that are unlikely to be repaid.

Those concerns are trumping expectations about a wave of consolidation likely to sweep the sector, with cooperative banks under pressure to merge following a government reform to reduce the number of lenders.

On Monday, Italy’s banking index fell 5.7 percent with Monte dei Paschi di Siena the biggest loser with a 14.8 percent drop.

The slump, which also hurt the bank’s riskier junior debt , prompted Italian market regulator Consob to introduce a temporary ban on short-selling.

Monte dei Paschi CEO Fabrizio Viola said in a statement on Monday the bank was financially sound and the share drop unwarranted.

Italy’s oldest bank, the only Italian lender to be bailed out during the financial crisis, is saddled with problematic loans equal to more than a fifth of its total client loans.

JP Morgan said this month Italian banks should be avoided because low interest rates are expected to put pressure on revenues more than in other countries and credit problems limit a recovery in provisions.

Traders have suggested exiting investments that have been particularly favoured, such as Popolare di Milano and Intesa, as the stocks have reached key support levels.

“I think upside on cooperative banks this year is much more limited,” said a London-based equity sales person.

A government reform of Italy’s top 10 cooperative banks forces them to turn into joint-stock companies by year-end, making them potential takeover targets.

Talks among the main players -- UBI, Popolare di Milano and Banco Popolare -- about defensive mergers are under way.

Analysts say stimulus measures by the European Central Bank have helped an economic recovery but have the side effect of putting bank margins under pressure. They say more turbulence is to expect in their stocks as markets are being rattled by woes over China and the oil prices.

But some fund managers maintain their positive bets on a sector where valuations are in some cases below rivals elsewhere in Europe.

“I would look at calls to exit Italian banks with a pinch of salt,” Gilles Guibout, portfolio manager at AXA IM, said.

“Consolidation has not yet happened but it will and then allow market repair and bring in efficiencies.” (Additional reporting by Valentina Za, Stefano Rebaudo, Giulio Piovaccari; Editing by Keith Weir and Adrian Croft)