UPDATE 1-Resona to buy back shares from Merrill

*To buy back $2.8 bln of preferred shares from Merrill Lynch

*Will raise core Tier-1 cap ratio to 5.9 pct from 5.1 pct

TOKYO, July 31 (Reuters) - Japan's Resona Holdings (8308.T) said it would buy back 271.3 billion yen ($2.8 billion) of its preferred shares from Merrill Lynch & Co and issue 104 billion yen worth of common shares to the U.S. brokerage to improve the quality of its capital.

Resona sold the preferred shares, which are convertible to common stock, to Merrill for 350 billion yen in 2007. Japan's fourth-largest bank said at the time it would use the proceeds from the sale to repay government bailout money.

The deal would allow Merrill, which is now a unit of Bank of America Corp (BAC.N), to convert the preferred shares into common stock after a lock-up period.

If converted at the lower limit conversion price of 867 yen it would have increased the number of Resona's common shares by about 400 million, or roughly 30 percent.

Resona said in a statement it will raise about 104 billion yen by issuing 75 million common shares, thereby minimising the dilution to existing shareholders.

The deal will at the same time raise Resona's core Tier-1 capital ratio, a measure of financial strength, to 5.9 percent from 5.1 percent at the end of March, according to a spokesman for the bank.

Resona, effectively nationalised after it nearly collapsed under a mountain of bad loans, received 3 trillion yen of taxpayer money in a 2003 bailout and earlier recapitalisations of Japanese banks. It has been steadily repaying that debt.

Shares of Resona closed at 1,398 yen before the announcement on Friday. The common shares will be issued at 1,382 yen each. (Reporting by Taiga Uranaka and David Dolan; Editing by Rupert Winchester)