By Valentina Za and Tommy Reggiori Wilkes

MILAN/LONDON (Reuters) -Rome's determination to have a say in the reshaping of Italy's financial sector has made things increasingly unpredictable for investors who have waited years for consolidation of the country's fragmented banking landscape.

UniCredit and its CEO Andrea Orcel are locked in a standoff with the Italian government over the bank's bid for smaller rival Banco BPM.

Italy's second-largest lender said on Friday it would challenge in court the conditions the government has imposed for its bid to proceed, after securing a 30-day suspension of the offer while it disputes Rome's demands.

Italy has special powers it can use to protect national security interests but these have become a major hurdle to some of the M&A efforts in the banking sector.

"Things have turned out completely differently than expected," said David Benamou, chief investment officer at Axiom Alternative Investments, whose European bank fund holds positions in some Italian lenders.

"There are many moving parts and when politics get involved it's much more difficult to anticipate the drivers."

Andreas Kokkinis, an associate professor at the University of Birmingham's law school, who has published work on bank corporate governance, described the conditions Rome has placed on UniCredit's bid for BPM as "unusual".

"This is clearly motivated by 'national interest' type of concerns and not merely by financial stability or customer protection concerns," he said, adding that this type of behaviour can harm shareholders as well as economies.

Italian Economy Minister Giancarlo Giorgetti has defended the government's right to vet banking deals, saying EU states are in charge of national security.

The ministry did not immediately reply to a request for comment.

The government was one of the instigators of the dealmaking flurry, when in November it sold a stake in Monte dei Paschi di Siena. That has since led to seven banking takeover offers in just six months.

POLITICS VS MONEY

Politicians' desire to influence the make-up of their banking industries - motivated partly by job protection - is playing out elsewhere in Europe too, slowing the consolidation that bank executives and supervisors say is needed.

Germany opposes UniCredit's ambition to acquire Commerzbank, and the Spanish government is unhappy about BBVA's bid for domestic peer Sabadell.

Investors see Italy as a testing ground for the merger activity that would help European banks close a profitability and valuation gap with U.S. rivals.