By Akiko Kashiwagi and Peter S. Goodman
Washington Post Foreign Service

TOKYO, July 16 -- Two of Japan's biggest financial institutions on Friday announced plans to merge and create the world's largest bank, underscoring growing sentiments that the country's long troubled banking system has significantly improved.

The marriage of Mitsubishi Tokyo Financial Group Inc., Japan's second-largest bank, with UFJ Holdings Inc., the fourth-biggest, would create an institution with some $1.7 trillion in assets, outstripping the country's current leader, Mizuho Financial Group, and the global leader, Citigroup Inc. The newly forged company would have nearly 80,000 employees and more than 1,000 branches around the world.

The details of the planned merger remained to be resolved through negotiations to be held in coming days, officials from the two banks said at a news conference Friday evening. Earlier on Friday, the banks notified the Tokyo Stock Exchange that they are pursuing an agreement and hope to have a preliminary deal signed by the end of the month, with the objective of completing the merger by September 2005.

Other banks seemed likely to mount legal challenges, but if the deal is consummated, Japan's financial system would be dominated by three vast conglomerates: the combined UFJ-Mitsubishi group alongside Mizuho and the Sumitomo Mitsui Financial Group.

Analysts praised the proposed merger as a substantial step forward in efforts to cleanse Japan's banks of bad loans estimated to exceed $500 billion. The bad debt is the legacy of the collapse of Japan's real estate market in the early 1990s combined with a cultural aversion to failure that has kept credit flowing to many insolvent companies even as they have continued to lose money.

Economists have long feared that the bad debts choking Japans banks could trigger a financial meltdown in the world's second-largest economy, sowing crisis around the globe. Consolidation has been seen as a key means of averting crisis by combining troubled lenders with institutions whose books are in stronger shape.

"This should remove any lingering doubts about the stability of the financial system," declared Richard Jerram, chief economist with ING Financial Markets in Tokyo, in a report circulated earlier this week. "In terms of ending fears of financial system crisis, this is probably not the beginning of the end, but the final step."

Japan's prime minister, Junichiro Koizumi, and his economic policy czar, Heizo Takenaka, have made bank cleanup among their highest policy goals. They have pressured lenders to cut credit to insolvent companies, with Takenaka declaring that under his reign no company would be deemed too big to fail. Takenaka has vowed to cut in half the amount in bad loans held by major Japanese banks by next March.

The Mitsubishi Tokyo-UFJ deal reflects the progress-through-consolidation idea that has prevailed within Japan's banking system. Japan's most deeply indebted bank, UFJ, has a reputation as one of the country's shoddiest lenders and faces possible criminal prosecution from regulators for trying to conceal the full extent of its $36 billion in bad loans. The bank declared losses of $3.7 billion for the fiscal year that ended in March. Mitsubishi Tokyo, on the other hand, is widely seen as one of the stronger banks. As of the end of March, only about 3 percent of the loans on its books were classified as bad, as compared to nearly one-tenth of UFJ's debts.

Still, the banks dismissed speculation that the merger amounted to a government-orchestrated shotgun wedding. Mitsubishi Tokyo chairman Shigemitsu Miki told reporters that the merger was his idea, advanced during a meeting with UFJ president Ryosuke Tamakoshi at the end of May.

"We have been aiming to become one of global 10, meaning one of the world's top ten banks," Mitsubishi Tokyo president Nobuo Kuroyanagi said at the news conference. We believe this merger will help us further boost our profitability, and help us achieve our goal.

Mitsubishi Tokyo has long resisted pressure from the government to take on a weaker partner. Bank officials portrayed the deal as a good strategic fit. Mitsubishi Tokyo has a strong stock of corporate clients and substantial international presence but relatively weak retail operations within Japan. Its new partner, UFJ, brings a widespread presence in the world of small- and medium-size Japanese businesses.

As for UFJ, which is essentially being taken over, the deal amounts to a rescue.

"UFJ was facing an emergency situation, but now has found a way to survive," said Yukiko Ohara, banking analyst at Credit Suisse First Boston in Tokyo. The bank had been left with a choice of either being bought or accepting a publicly funded bailout, she said. A bailout almost surely would have entailed government requirements to lay off managers and cut lending to favored customers.

Now that the future of UFJ has seemingly been determined, investors are shifting attention to the fate of its biggest borrowers -- not least the ailing retail chain Daiei, whose flirtations with bankruptcy have become something of a bellwether for the health of corporate Japan and the governments resolve in allowing failed companies to die.

Analysts said Mitsubishi Tokyo may demand that UFJ quickly minimize its exposure to Daiei, perhaps by shedding some of the loans and handing them off to the Industrial Revitalization Corporation, a state-funded institution charged with reviving ailing firms.

Despite Mitsubishi Tokyo's relative financial health, the merged entity will face skepticism about its combined balance sheet. As news of the merger spread, the credit rating agency Standard & Poors put three banks that are part of the Mitsubishi Tokyo conglomerate on a watch list for a possible downgrade, citing a higher level of bad loans once it assumes UFJ's liabilities.

One of the biggest questions remaining is whether the deal could be derailed by legal action. On Wednesday, as talk of the merger dominated Tokyo financial circles, Sumitomo Trust threatened to sue UFJ for damages stemming from an abandoned transaction previously agreed to by the two companies.

In May, UFJ, desperately in need of cash to shore up its balance sheet, announced that it would sell one of its banking arms to Sumitomo Trust for about $2.7 billion. But as its merger talks heated up with Mitsubishi Tokyo this week, UFJ swiftly announced that it would not go through with that deal, preferring to keep itself whole.

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