July 30 (Bloomberg) -- Sumitomo Mitsui Financial Group Inc., Japan's third-largest bank, will offer to merge with UFJ Holdings Inc. to create the world's biggest lender, setting up the first bidding contest among the nation's banks.

The Tokyo-based bank will join with Sumitomo Trust & Banking Co. and lodge a bid, countering a merger proposal from Mitsubishi Tokyo Financial Group Inc., President Yoshifumi Nishikawa told reporters outside his Tokyo home. UFJ has a market value of $20 billion.

The rival bids are targeting a bank with Japan's heaviest bad loan burden, which caused losses of $20 billion in the past three years. Sumitomo Mitsui's move is a departure from earlier mergers that created the country's biggest banks and were pushed through by the government.

``Competitive bidding is common in the U.S. and Europe and finally we are witnessing a change of the tide in Japan, which is good for the economy'' said Nobumichi Hattori, a professor at Hitotsubashi University and a former head of mergers and acquisitions at Goldman Sachs Group Inc. ``UFJ should let them compete and choose whoever offers the highest premium.''

Sumitomo Trust agreed to buy UFJ's trust business in May for at least 300 billion yen then in July scrapped that sale in favor of a merger with Mitsubishi Tokyo. A Tokyo court this week ruled that UFJ must respect its agreement with Sumitomo Trust.

A merger between Sumitomo Mitsui and UFJ would create a lender with 184.3 trillion yen ($1.64 trillion) of assets, surpassing Citigroup Inc. as the world's largest bank.

Seeking Partners

Shares of Mitsubishi Tokyo fell as much as 3.9 percent on the Tokyo Stock Exchange. Sumitomo Mitsui gained 3 percent while UFJ surged 8.2 percent.

UFJ is seeking a partner to reduce 3.94 trillion yen of bad loans and as it faces possible criminal charges for hiding information about those loans. Sumitomo Mitsui and Mitsubishi Tokyo would be able to expand lending to small companies and asset management business as the nation's economy extends its longest recovery in seven years.

``It's the first bidding war among Japanese banks,'' said Hirofumi Kasai, chief investment officer of Tokio Marine Asset Management Co., which manages the equivalent of $10 billion including shares of Mitsubishi Tokyo. ``The big shareholders of UFJ -- Toyota or Fidelity -- will have to decide which offer to chose.''

Continuing Talks

Fidelity Investments Japan Ltd. owned about 6.6 percent of outstanding shares of UFJ as of March 31, according to disclosures to Japan's Ministry of Finance. Toyota Motor Corp., Japan's largest automaker, held 2.7 percent of UFJ shares.

Hisayo Yokota, a spokeswoman at Fidelity's Tokyo office, couldn't immediately comment. Toyota spokeswoman Shino Yamada declined to comment.

``Sumitomo Mitsui possibly has better chances of winning the bidding war, as Toyota is close to Sumitomo Mitsui,'' Kasai said.

Officials at Mitsubishi Tokyo and UFJ said plans to merge the two banks are proceeding. ``The fact is we have not heard from Sumitomo Mitsui,'' said UFJ Bank President Takamune Okihara, adding that the ``direction'' of UFJ's merger talks with Mitsubishi Tokyo is unchanged.

``I was not aware of the move,'' said Shigemitsu Miki, chairman of Bank of Tokyo-Mitsubishi Ltd., referring to a report in the Asahi newspaper about Sumitomo Mitsui's plan. ``We will never change our plan to merge with UFJ.''

``We will continue the talk with UFJ for the trust merger,'' Sumitomo Trust said in a statement.

Creating a Megabank

A merger between Mitsubishi Tokyo, Japan's most profitable lender, and UFJ would create a lender with 188 trillion yen of assets.

``The competition in the merger area is actually a very, very good thing,'' said Jesper Koll, chief economist at Merrill Lynch Japan Inc. ``Tokyo Mitsubishi is a big Tokyo-based bank that doesn't have a lot of retail business and that doesn't have a lot of business with small and medium size companies, while UFJ offers exactly that.''

Still, Mitsubishi Tokyo and Sumitomo Mitsui may be entering a quagmire by acquiring UFJ after the unprofitable lender admitted this week to government charges its senior officials masterminded forging of documents and evading government audits to hide bad loans, said fund manager Charles Lahr.

``Whoever gets UFJ will be overpaying and bailing out a distressed franchise,'' said Lahr, who helps manage $30 billion for New Jersey-based Franklin Resources Inc. and sold all Japanese bank shares this year. ``Why should shareholders be expected to do that?''

Adding Divisions

Sumitomo Mitsui's Nishikawa said a combined lender would be able to focus on small and medium-sized companies and consumer finance and retail business.

The bank last year added five corporate divisions and 39 new outlets to strengthen its lending to smaller businesses. Sumitomo Mitsui aims to triple lending to small business to 3.6 trillion yen as of March 2007, compared with 1.258 trillion yen at the end of March last year.

Japanese banks want to increase lending and make loans more profitable without incurring more risk. Lending has fallen each month since the Bank of Japan started tracking data in January 2001, and loan margins average 1.7 percent, about half those achieved in the U.S.

``We (Sumitomo Mitsui and UFJ) are very close in terms of culture, and we share a lot of business in Kansai and Tokai area,'' Nishikawa said. ``I am on good terms with officials at UFJ.''

To contact the reporter on this story: Takahiko Hyuga in Tokyo thyuga@bloomberg.net

Last Updated: July 29, 2004 23:22 EDT