Mitsubishi UFJ Financial Group (8306.T), Japan's No. 1 lender by assets, on Tuesday reported a sharp fall in profit in the April-June period, hurt by the effect of a hefty one-time gain from its stake in Morgan Stanley (MS.N) booked a year earlier, but profit of No. 2 Mizuho Financial Group (8411.T) nearly doubled thanks to hefty returns from its bond portfolio.

MUFG, Mizuho and No. 3 Sumitomo Mitsui Financial Group (8316.T), which announced results on Monday, saw profits from lending activities continue to fall as both domestic loan volumes and interest margins shrank.

"The overall trend has not changed for Japanese banks," said Chikako Horiuchi, director at Fitch Ratings in Hong Kong. "We have been waiting to see the bottom-out of domestic lending, but it remains weak and we have been waiting to see the peak-out of bond trading gains, but it remains strong," she said.

Lending by Japan's major banks fell year-on-year for a 32nd straight month in June, Bank of Japan data shows, underlining prolonged weakness in loan demand from large businesses struggling with Japan's fragile growth prospects.

As a result, the banks have increasingly relied on bond trading profits in recent years. All the three big banks enjoyed huge bond trading gains in the April-June quarter.

Japanese government bond and U.S. Treasury prices surged in the quarter as persistent worries about Europe's debt crisis and increasing signs of sluggish global growth helped to underpin demand for debt from sovereign issuers still considered safe havens.

VULNERABLE TO MARKET SWINGS

MUFG, which owns California-based Union Bank, said its quarterly net profit fell 64 percent to 182.9 billion yen ($2.3 billion) down from 500.6 billion yen a year earlier, when it booked a 290 billion yen one-time gain from converting its preferred shares in Morgan Stanley.

MUFG rode to the rescue of Morgan Stanley at the height of the financial crisis, buying $9 billion of convertible preferred shares from the U.S. investment bank in October 2008.

The bank kept its full-year net profit forecast at 670 billion yen, down from 981.3 billion yen a year earlier and slightly below the 678.5 billion yen average estimate in a poll of 18 analysts by Thomson Reuters.

Mizuho said April-June net profit nearly doubled to 183.9 billion yen ($2.4 billion) from a year earlier.

The bank kept its full-year net profit forecast at 500 billion yen, up 3.1 percent from a year earlier and above an average estimate of 450.5 billion yen in a poll of 18 analysts by Thomson Reuters.

SMFG on Monday reported a 43 percent fall in its financial first quarter profit, dragged down by impairment losses on its equity portfolio as the benchmark Nikkei average declined 10.7 percent during the three-month period.

Japanese banks' massive equity portfolios, a consequence of the traditional business practice of taking equity stakes in their clients, make them highly vulnerable to market swings. MUFG and Mizuho also suffered stock-related losses of a similar scale during the period.

OVERSEAS GROWTH

One bright spot was overseas growth, with all of the three banks seeing their overseas loan balances grow during the period.

With little exposure to Europe's debt crisis, Japanese banks are seen as better positioned to take advantage of European rivals' retreat in Asia and other regions.

MUFG, SMFG and Mizuho ranked second, third, fourth in the league table of global project finance mandated arrangers for the first six months of this year, Thomson Reuters data showed.

Last month, Mizuho said it had agreed to buy a Brazilian unit of Germany's WestLB WDLG.UL, the latest move by a Japanese bank to snap up assets as European rivals withdraw from overseas markets.

MUFG, whose UnionBanCal unit in March agreed to buy California-based Pacific Capital Bancorp (PCBC.O) for about $1.5 billion, has said it may spend more than 1 trillion yen in the next three years on overseas acquisitions.

Shares of MUFG and Mizuho rose 18 and 26 percent respectively so far this year, outperforming a 2.7 percent gain in the Nikkei average N.225.

(Editing by Alex Richardson)

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