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Shinsei Bank and Aozora Bank have reached a basic agreement to merge next year and create Japan’s sixth-largest banking group in terms of assets, sources said Thursday.

The Tokyo-based banks decided on the merger to help improve their financial standing and profitability, which have been badly hurt due to their aggressive investment in high-risk financial instruments overseas that crumbled in the global financial crisis, the sources said.

The banks will formally announce the merger early next month, the sources said.

Shinsei and Aozora tried to make up for their weak domestic operations with the heavy overseas investments. With the stunning failure of that strategy, they now plan to shift their focus to primary banking operations for domestic corporate clients and individuals, the sources said.

The merger will create an institution with more than ¥18 trillion in assets, topping Chuo Mitsui Trust Holdings Inc. as the sixth-largest Japanese commercial banking group.

Both banks were formerly providers of long-term credit to businesses and are owned chiefly by U.S. investment firms.

J.C. Flowers & Co. owns 33 percent of Shinsei’s outstanding shares, while Cerberus Capital Management L.P. has a stake of more than 50 percent in Aozora in terms of voting rights.

Both were temporarily nationalized during the banking crisis in 1998 before returning largely to private ownership in 2000. Since then they have been revamping their operations under the guidance of the U.S. shareholders and others.

The government still owns a part of each. Shinsei still has to pay back about ¥220 billion in public money, while Aozora owes taxpayers ¥180 billion.

The two banks are considering applying for an injection of more public money in the face of their slack business performance, the sources said.

In the business year that ended last March 31, Shinsei fell into the red with a group net loss of ¥143.0 billion, while Aozora suffered ¥242.5 billion in net loss.

Both are at high risk of receiving business improvement orders from the Financial Services Agency.

J.C. Flowers and Cerberus initially appeared to disagree on which should take leadership after the merger, but their differences have been overcome, the sources said.

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