UPDATE 2-Shinsei shares slide on report of no Aozora merger

* Shinsei, Aozora to abandon or postpone merger -Nikkei

* Rating outlooks of banks may be returned to 'Stable'-S&P

* Shinsei may need to raise capital on its own -analyst

* Shinsei shares end down 6.7 pct; Aozora up 0.9 pct (Adds S&P on banks' ratings outlooks; closing share prices)

By David Dolan

TOKYO, Feb 15 (Reuters) - Shares of Japan's Shinsei Bank (8303.T) fell 6.7 percent on Monday to a near three-month closing low after a report the lender and Aozora Bank (8304.T) will scrap a plan to merge in October.

The two midsized lenders will abandon or indefinitely postpone the deal, which would have created Japan's sixth-largest bank by assets, because they could not decide on a business strategy, the Nikkei newspaper said on Saturday. [ID:nSGE61B0DR]

Shinsei said in a statement over the weekend that it had no comment on the report, while Aozora said in a statement on Monday it had made no decisions that need to be disclosed.

Shares of Shinsei ended down 7 yen at 97, their lowest close since November 25, reflecting concern that Shinsei will need to raise more funds if it remains independent.

Nearly 21 million Shinsei shares changed hands on Monday, more than two-thirds the average daily volume traded over the past 90 days. Aozora ended up 0.9 percent after falling as much as 4.6 percent.

"For Shinsei, one of the weaknesses is capital. Aozora had a stronger capital base," said Ehsan Syed, credit analyst at Fitch Ratings in Tokyo.

"If the two banks don't merge, and considering the coming stricter regulations on banks, Shinsei will probably have to raise capital on its own," he said.

The Basel Committee on Banking Supervision, made up of central bankers and financial supervisors from nearly 30 countries, published draft reforms in December calling on banks to improve their capital buffers to prevent another financial crisis.

Many analysts expect that Basel will require banks to keep a minimum Tier-1 capital ratio of 8 percent. A Tier-1 ratio is a measure of a bank's financial strength.

Shinsei had a Tier-1 capital ratio of 7.83 percent as of the end of December. It had been at 6.02 percent as of the end of March 2009.

By contrast, Aozora had a much more robust Tier-1 ratio of 14.2 percent at the end of Sept 2009.

SLOW PROGRESS

Shinsei Chief Financial Officer Rahul Gupta acknowledged in a conference call with reporters earlier this month that the merger talks were "progressing slowly".

The Nikkei reported in January that the merger would likely be delayed, due to difficulties with systems integration and pending the outcome of inspections by Japan's regulator, the Financial Services Agency.

Both banks were undergoing inspections and may need to rejig their one-for-one merger ratio pending the outcome, the Nikkei said at the time.

The outcome of those inspections is still unclear, but Shinsei said this month it may need to make additional reserves and write-downs related to some of its real estate loans and its consumer finance business.

It is also unclear whether there have been difficulties between the major shareholders of both banks. Shinsei is about one-third owned by buyout firm JC Flowers and Co, while Aozora is majority owned by Cerberus Capital Management [CBS.UL].

Both banks have struggled to post convincing profit growth in recent years.

As relatively small players in Japan's crowded banking market, both made hefty investments overseas in an attempt to better compete with larger rivals such as Mitsubishi UFJ Financial Group (8306.T) and Sumitomo Mitsui Financial Group (8316.T).

However, those investments backfired during the credit crisis and the two lenders lost a combined 385.6 billion yen ($4.3 billion) in the year to March 2009.

The banks announced their plans to merge in July, just months after posting the heavy losses. They have since returned to profit, meaning the merger may be less of a priority than during the financial crisis.

Both banks have yet to fully repay the 621 billion yen of bailout money they received following Japan's banking crisis in the 1990s, which gives the FSA additional oversight over the institutions.

An end to the merger plan may not be all bad news for the banks, though.

Ratings agency Standard & Poor's said on Monday if the merger is cancelled, it may remove the ratings on both banks from 'CreditWatch with positive implications' and return the outlooks to 'stable' as the 'likelihood of government support being extended to the banks may decrease'.

The Nikkei said the FSA is expected to urge the two banks to come up with new business strategies.

Shinsei will work on a plan to raise its capital ratios, while Aozora will seek growth through alliances with local banks, the paper said.

Over the last two years Shinsei has lost about 78 percent of its market value and Aozora has lost about 63 percent. ($1=90.05 Yen) (Editing by Muralikumar Anantharaman)