UFJ Holdings Inc. and Mitsubishi Tokyo Financial Group Inc. — two of Japan’s four major banking groups — said Friday they have agreed to start merger talks, aiming to integrate their operations during the first half of fiscal 2005.

They aim to sign a basic agreement by the end of this month on a plan to merge and measures to boost UFJ’s capital.

The deal would create the world’s largest banking group, with 190 trillion yen in assets.

UFJ Holdings President Ryosuke Tamakoshi told a joint news conference that the merger would help the UFJ Bank accelerate disposal of the bank’s bad loans.

“It would be too late to compete with other major banks after we finish clearing those debts, when other mega-banks are becoming increasingly competitive,” Tamakoshi said.

The planned merger would leave Japan with three major banking groups, including Mizuho Financial Group and Sumitomo Mitsui Financial Group.

In order to help UFJ write off its bad loans, MTFG said it would help UFJ boost its capital.

Large borrowers from the UFJ group include supermarket chain Daiei Inc., trading house Sojitz Corp., and condominium builder Daikyo Inc. Writing off loans to these firms, which are being rehabilitated, is extremely important for UFJ.

“We plan to solve the problems of large indebted borrowers before integration,” Tamakoshi said.

As of March 31, UFJ held bad loans worth 3.9 trillion yen, or 8.5 percent of overall outstanding loans, exceeding the target set by the government to cut the ratio to 4 percent by the end of the current fiscal year.

The agreement, which analysts see as a rescue takeover by MTFG, may soothe fears of instability in Japan’s financial system stemming from UFJ’s financial troubles.

MTFG said Friday that merging with UFJ would boost its competitiveness by reinforcing its retail banking operations and business with small companies, which are UFJ’s strength. MTFG’s main strength is in dealing with overseas business and large-scale domestic firms.

But the planned merger faces difficulties.

The Financial Services Agency in June slapped UFJ Holdings with a series of business-improvement orders over its attempt to evade an agency inspection, its inappropriate handling of loans to small companies and operational problems.

UFJ Holdings also has to deal with a legal challenge from Sumitomo Trust & Banking Co. over its decision to back out of the plan to sell its trust unit, UFJ Trust Bank, to Sumitomo Trust.

As part of efforts to rebuild management, the UFJ group had decided to sell UFJ Trust to Sumitomo Trust for business integration, hoping to improve its financial position with proceeds from the sale. But it concluded that it would not be sufficiently rehabilitated with a business alliance only in the trust division, banking sources said.

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