Aug. 26 (Bloomberg) -- Japan's stocks dropped the most in a week, led by financial companies, after HSBC Holdings Plc said real estate failures will increase bad loans at regional banks.

Fukuoka Financial Group Inc., Japan's second-largest regional lender by assets, and Suruga Bank Ltd. slumped after HSBC cut their ratings. Developer Asahi Homes Co. plunged 28 percent, its sharpest drop in six years, after its largest shareholder filed for bankruptcy. Shimamura Co. led declines by retailers after reporting slower sales.

``Economies in rural areas haven't improved at all, and regional banks probably had no choice but had to expand their exposure to real estate,'' said Hiroshi Morikawa, a Tokyo-based senior strategist at MU Investments Co., which manages the equivalent of $14 billion. ``We've got to be vigilant for developments in the regional banking sector.''

The Nikkei 225 Stock Average dropped 99.95, or 0.8 percent, to 12,778.71 at the close of trading in Tokyo, paring a decline of as much as 1.7 percent. The broader Topix index slipped 9.90, or 0.8 percent, to 1,229.35. Both gauges retreated by the most since Aug. 19.

All but five of the 33 industry groups on the Topix slumped. The value of shares traded on the main board of the Tokyo exchange was to the lowest all year.

Fukuoka Financial slumped 4 percent to 405 yen, the lowest value since its listing as a holding company in April 2007. Suruga Bank dropped 3.4 percent to 1,180 yen. Nomura Holdings Inc., Japan's largest brokerage, fell 2.1 percent to 1,420 yen. Orix Corp., Japan's largest non-bank financial company, lost 2.7 percent to 13,180 yen.

Real Estate Risk

Kentaro Kogi, a Tokyo-based analyst for HSBC, today cut his ratings on Japanese regional banks including Fukuoka, saying rising bankruptcies among real-estate companies will drive up provisions and bad-loan costs over the next two years. He lowered his recommendations on Fukuoka and Bank of Yokohama Ltd. to ``underweight'' from ``neutral'' and Suruga Bank and Chiba Bank Ltd. to ``neutral'' from ``overweight.''

``We could see a trend of more domestic banks disposing of their non-performing assets as we move towards September earnings, which could lead to earnings downgrades,'' said Mitsushige Akino, who oversees the equivalent of $468 million at Ichiyoshi Investment Management Co. in Tokyo.

Asahi Homes plunged 28 percent to 42 yen, the biggest drop since September 2002. Parent company Sebon Corp. filed for bankruptcy with debt at 60 times its capital, it said yesterday after markets shut. Bankruptcies among property companies more than doubled to 60 in July from a year earlier, according to Tokyo Shoko Research Ltd.

Tokyo Tatemono Co. fell 2.8 percent to 549 yen, while Tokyu Land Corp., which develops properties in west Tokyo, lost 3.5 percent to 475 yen.

Retailer Slump

Shimamura, which operates clothing outlets nationwide, slumped 4.2 percent to 5,990 yen, the lowest since July 2. Aeon Co., Japan's second-largest retailer, fell 4 percent to 1,217 yen. Isetan Mitsukoshi Holdings Ltd., the country's No. 1 department store chain, declined 3.2 percent to 1,174 yen.

Shimamura reported a 6.8 percent decline in same-store-sales in August from the previous year, it said yesterday. Inventory turnover rates at the nation's leading clothing retailers are falling as companies struggle to sell their goods, the Nikkei newspaper reported today.

Piano-maker Yamaha Corp. rallied 3.2 percent to 1,859 yen, after the Kabushiki Newspaper said the company's management is in talks with Mizuho Corporate Bank Ltd. to conduct a management buyout. Yamaha denied such negotiations were occurring.

Nikkei futures expiring in September fell 0.7 percent to 12,780 in Osaka and in Singapore.

To contact the reporters for this story: Patrick Rial in Tokyo at prial@bloomberg.net; Masaki Kondo in Tokyo at mkondo3@bloomberg.net.

Last Updated: August 26, 2008 02:54 EDT