updated 7/16/2004 2:16:42 PM ET 2004-07-16T18:16:42

UFJ Holdings Inc., Japan’s fourth biggest banking group, and larger rival Mitsubishi Tokyo Financial Group Inc. have agreed to discuss a possible merger that could create the world’s biggest bank, both sides said Friday.

The banks — two of Japan’s “Big Four” megabanks — said they hope to reach a basic agreement by the end of the month on a deal that would allow them to merge by September 2005. Terms of a deal, such as how big a stake each bank would own in the new company, job cuts and other details, were undecided, officials said.

On Wednesday, money-losing UFJ put in a request with Mitsubishi Tokyo to consider a merger. But bank executives said they had conducted informal talks since May.

“Unfortunately we have fallen behind other financial groups in getting rid of bad loans,” UFJ Holdings president Ryosuke Tamakoshi told reporters at a Tokyo hall. “With a merger we are hoping to advance at once to the next step.”

With combined total assets of around 188 trillion yen ($1.7 trillion), UFJ and Mitsubishi Tokyo would create the world’s largest bank by assets, surpassing U.S.-based Citigroup Inc.’s $1.19 trillion in assets.

The move by the banks underlines a streamlining trend in the nation’s long-struggling financial system. All of the Big Four, which also includes Mizuho Financial Group and Sumitomo Mitsui, were formed in recent years through mergers.

Analysts say a UFJ-Mitsubishi Tokyo merger could face more bumps along the way because of the scale of bringing together such big banks. Job cuts will also likely be necessary, they say. UFJ also has some problematic borrowers, including major retailer Daiei.

Among the other obstacles for the merger is an objection from Sumitomo Trust, which reached a deal in May to buy UFJ’s trust banking operations. UFJ said this week it was scrapping the deal with Sumitomo Trust.

Sumitomo Trust put in a request with Tokyo District Court Friday to halt the merger talks, but its request stopped short of a lawsuit. Sumitomo Trust President Atsushi Takahashi lambasted UFJ’s decision to dump their deal on the trust business sale, saying it threatens Japan’s international credibility.

UFJ refused comment, saying it had yet to receive an official notice.

But analysts and the Tokyo stock market have generally welcomed the possible merger as positive for the overall banking industry. A merger would resolve nagging fears about the fate of UFJ, which was reprimanded by the Financial Services Agency last month for being evasive during regulatory inspections.

“I think overall I would take it as quite positive in combining Tokyo Mitsubishi’s strong balance sheet with UFJ’s strengths in consumer and small company lending,” said Ned Akov, bank analyst with ING Securities (Japan) in Tokyo. “Integration will be a challenge given the sheer size of the institutions.”

UFJ is strong in the retail market and has key corporate clients such as Japan’s top automaker, Toyota Motor Corp. Mitsubishi Tokyo has strong international operations and boasts a list of major corporate clients, including companies in the Mitsubishi group.

Standard & Poor’s has said it may lower its credit rating for Mitsubishi Tokyo, Japan’s second-largest bank and one of its healthiest, if it pursues the merger with debt-laden UFJ, while indicating it may raise its ratings for UFJ. Moody’s Investors Service said Friday it may upgrade both banks.

The other three Big Four banks were profitable for the fiscal year ended March 31, but ballooning bad debts kept UFJ Holdings in the red and forced its top executives to step down. UFJ reported a loss of 402.8 billion yen ($3.7 billion) for the latest fiscal year — its third straight year of losses.

Both banks shares finished lower on the Tokyo Stock Exchange Friday, although there was a rush order earlier in the week. Mitsubishi Tokyo lost nearly 9 percent, while UFJ dropped 3 percent, a few hours before the joint news conference.

Mitsubishi Tokyo president Nobuo Kuroyanagi said he was hopeful the merger will help the new financial group become more globally competitive.

“We want to beat global competition to come up with top-rate financial products and services,” he said.

The decade-long slowdown in the world’s second largest economy, which has only recently shown signs of abating, has taken its toll on Japanese banks. They became saddled with huge bad debts, and the government has been stepping up pressure on them to come clean.

Japan’s top business newspaper, Nihon Keizai Shimbun, reported Friday that Mitsubishi Tokyo is willing to take on UFJ despite its problems because of its need to grow to fight Japanese rivals as well as possible foreign players that could have taken over UFJ.

Big Japanese banks, which worked with the government to finance Japan’s modernization over the decades after World War II, have been criticized as notoriously inefficient and unprofitable compared to their Western counterparts.

“With a merger, megabanks will be trimmed to three,” the Nihon Keizai said. “But the battle will be over what kind of services the three giants can offer.”

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