Nationalization of Citigroup Inc is a trap that the U.S. government should avoid as such a step would likely cause all bank stocks to get crushed in fear, an analyst at Fox-Pitt Kelton said.

Citigroup is in talks that could see the U.S. government take a bigger stake, a source told Reuters, sparking a recovery in the battered share price of what was once the country's most valuable bank.

Government intervention in Citigroup's operations is completely unnecessary as long as depositors are calm, and the government should not set a precedence of catering to the stock market's fears and the associated pressure from the media, analyst David Trone said in a note to clients.

The government could harmfully meddle in Citi's operations and strategy, and many potential customers and employees will avoid Citi, making it unprofitable even in normal times, Trone said.

"If we're right, the govt will have a hard time ever selling its stake back to the public markets."

UBS said it is unclear why banks need to be nationalized right now if they have ample liquidity and can continue to operate until the economic environment improves.