Jan. 31 (Bloomberg) -- Mitsubishi UFJ Financial Group Inc. and Sumitomo Mitsui Financial Group Inc. reported falling earnings in the third quarter as they struggled to raise loan rates amid flagging consumer spending in Japan.

Mitsubishi UFJ, Japan's biggest bank, posted a 42 percent decline in net income in the three months ended Dec. 31. Sumitomo Mitsui, the No. 3 bank, recorded a 26 percent drop. Mizuho Financial Group Inc., Japan's second-largest bank, had a 23 percent slide in profit.

Japan's longest postwar expansion has failed to translate into wage growth and rising consumer spending, curbing demand for loans. The central bank has remained on hold since raising its target rate in July, limiting the scope for banks to increase lending rates.

``The banking business reflects the wider economy, which isn't too healthy,'' said Reiko Toritani, an analyst at Fitch Ratings in Tokyo. ``The banks are suffering from low interest rates and little demand for loans.''

Tokyo-based Mitsubishi UFJ's net interest income fell 7.8 percent in the quarter. At Sumitomo Mitsui, income from lending fell 8.2 percent. Mizuho boosted net interest income by 2.8 percent. Bloomberg News calculated the figures by subtracting first-half numbers from nine-month earnings announced today.

The banks' declining profits partly reflect rising expenses related to bad loans, with Mitsubishi UFJ setting aside 76 billion yen in write-offs and provisions.

Rates on Hold

Falling profit from lending may disappoint investors who expected interest margins to increase after the Bank of Japan raised its target rate by a quarter percentage point in July. Mitsubishi UFJ President Nobuo Kuroyanagi last week called competition in lending among Japanese banks ``severe.''

``Banks have a short-term problem in that their lending margins are not expanding, as was expected, despite the increase in money rates,'' said Scott McGlashan, who manages the equivalent of $417 million of Japanese stocks at J O Hambro Capital Management Ltd. in London.

Investors have pared bets that the BOJ will raise rates further as economic growth failed to trigger rising consumer spending. Governor Toshihiko Fukui this month held the key interest rate at 0.25 percent, the lowest among the world's major economies.

Contracts for the exchange of overnight interest rates today showed a 38 percent chance Fukui will raise borrowing costs in February, down from 69 percent on Jan. 18 when the bank had its last policy meeting, according to data compiled by Zurich-based Credit Suisse Group.

Wages Drop

The 85-member Topix Banks Index has declined 2 percent since Jan. 18 after climbing 9.5 percent in the two months before the BOJ meeting.

``Loan margins probably bottomed out in the quarter,'' said Shinichi Tamura, a Tokyo-based analyst at UBS AG. ``They still need to widen further to increase net income.''

Japan's wages fell at the fastest pace in 16 months in December, the labor ministry said today, adding to evidence the economic expansion may sputter and weakening the case for further rate increases.

Household spending dropped for a 12th month in December, falling 1.9 percent from a year earlier, a government report showed yesterday.

``The BOJ is unlikely to raise rates,'' said Angus McKinnon, a Tokyo-based senior partner at Trident Pacific Capital, which manages $60 million of Japanese equities including bank shares. ``Consumption still remains rather weak.''

`Good Bets'

Total deposits at 125 banks in Japan amounted to 524 trillion yen on Dec. 31, exceeding the 414 trillion yen of loans outstanding, according to the Japanese Bankers Association. The surfeit of deposits is making it more difficult for Japanese banks to bolster lending and profits, McGlashan said.

Even so, the average rate on existing loans at large banks rose 0.18 percentage point from a year earlier to 1.59 percent in December, faster than in the previous month, the BOJ said yesterday.

Banks typically begin charging more for loans about six months after the central bank raises rates, while they boost deposit returns faster, said McKinnon. As Japan's economy continues to expand, lenders will gradually be able to raise interest margins, he said.

``Long term, the banks are good bets,'' McKinnon said. `` Generally banks tend to follow the economic recovery.''

To contact the reporter on this story: Mariko Yasu in Tokyo at myasu@bloomberg.net

Last Updated: January 31, 2007 04:35 EST