The deal will create a lender with more than 25,000 staff and four million customers, and could help drive consolidation among Italy's fragmented banking sector.
The deal has been delayed as the banks struggle to meet higher capital requirements, weighed down by hundreds of billions of euros of bad loans and weak economic growth.
Banco Popolare, which will own 54 percent of the new company, is seeking to raise €1 billion ($1.1 billion) of capital before the merger is completed by December, Bloomberg News reported.
"We are particularly pleased to have succeeded... given the severe and negative market conditions, in launching an operation as extraordinary and significant as the merger of Banco Popolare and Banca Popolare di Milano," said Banco Popolare president Carlo Fratta Pasini.
The as-yet-unnamed lender will have two headquarters - the legal side headed from Milan and administrative side in Verona.
With a market capitalisation of around €5.5 billion, €171 billion in assets and 2,500 branches, it will be Italy's number three lender behind Intesa Sanpaolo and UniCredit.
The European Central Bank has been piling pressure on Italy's banks to deal with their weak balance sheets, and the head of its supervisory arm on Tuesday said the merger must succeed.
"The bank has to be strong at the very beginning, this will be the third Italian bank, said Daniele Nouy, president of the ECB's Supervisory Council.
The merger is "a very important operation, it has to be a success, precisely because it's maybe the first of a series of other ones," she told the European Parliament's committee for economic and monetary affairs.
However, she warned that similar banking mergers elsewhere had "ended up creating a worse situation or difficulties for the banks coming from the merger".