* Banks beat market profit forecasts on stock-driven rally
* MUFG tips profit down 4 pct, Mizuho, SMFG profits down about 20 pct
* MUFG buoyed by overseas reach as domestic lending still subdued (Adds bond holdings, comment by analyst)
TOKYO, May 14 (Reuters) - Japan's three biggest banks beat market forecasts with record annual profits, fuelled by a stock market boom, but said earnings will fall this business year as the glow of "Abenomics" fades and lending gains remain restrained.
Mitsubishi UFJ Financial Group Inc (MUFG) on Wednesday forecast only a modest pullback in profit for the business year that began in April, while the other two "megabanks" expect double-digit declines.
Japan's biggest lender by assets will be buoyed by a greater overseas reach than the other two - Mizuho Financial Group Inc and third-biggest lender Sumitomo Mitsui Financial Group Inc (SMFG).
The divergence underscores the difficulty facing banks 17 months after Prime Minister Shinzo Abe took office on a pledge to end 15 years of deflation with loose-money stimulus policies.
"The Abenomics effect - rises in stock prices driven by low interest rates - comes first," Mizuho President Yasuhiro Sato told reporters. "The link to increased funding demand comes from here on."
MUFG said net profit rose 15.5 percent last business year to 984.8 billion yen ($9.63 billion), above the 944.1 billion yen mean estimate of 19 analysts polled by Thomson Reuters.
But for this year, MUFG - which owns about onefifth of Morgan Stanley - expects profit to slip 3.5 percent to 950 billion yen, still above the analyst forecast of 907.6 billion yen.
Mizuho's net climbed 23 percent to 688.42 billion yen, beating the analyst estimate of 664 billion yen. The bank expects profit to fall 20 percent this business year to 550 billion yen, near the market estimate of 558.2 billion yen.
SMFG booked a 5.2 percent profit rise to 835.36 billion yen, above the 799.8 billion yen consensus, but expects a pullback of 19 percent to 680 billion yen, near the market view of 689.7 billion yen.
NOW FOR THE HARD PART
The profit increases were propelled by factors that do not look likely to repeat. Japan's Nikkei 225 Stock Average rose 20 percent in the last fiscal year, boosting the value of the megabanks' massive shareholdings and the commission revenues at their brokerage subsidiaries.
The market is off 3 percent so far this business year as investors grow impatient that Abe will introduce the hard structural reforms to the word's third-biggest economy that are considered essential for sustainable growth.
Last business year also saw the banks cutting their bad-loan costs as the improving economy reduced the number of delinquent borrowers.
"It remains uncertain how much the banks can increase profits from their core lending activities," said Chikako Horiuchi, a credit analyst at Fitch Ratings in Hong Kong.
"Loan spreads remain thin and volume is unlikely to increase strongly enough to make up for it," she said. "Japan's corporate sector is cash-rich, so capital investment by business clients is unlikely to lead to a jump in loan demand anytime soon."
Loan balances ticked up 1 to 2 percent at the three banks last business year but returns continued to fall amid intense competition among the lenders. For example, the spread between the interest rate SMFG charges on loans and pays for deposits narrowed by 12 basis points to 1.37 percentage points.
The Bank of Japan launched a massive asset-buying programme in April 2013 in a bid to end 15 years of deflation and to spur banks into shifting from low-yielding Japanese government bonds into more aggressive lending.
MUFG cut its JGB holdings by 8 trillion yen last business year to 40.4 trillion yen. But the bank and the two rivals said they are simply parking the bulk of the proceeds with the central bank in the absence of borrowers.
MUFG, which aspires to be a top 10 U.S. bank by 2016, paid about $5 billion in December for 72 percent of Thailand's Bank of Ayudhya , adding 2 trillion yen to MUFG's overseas loan book.
The purchase will start boosting MUFG's profit in earnest this year, said analyst Nana Otsuki at Merrill Lynch Japan Securities before the results. Considering the profit relative to the amount of capital, however, MUFG's advantage is not particularly strong, Otsuki said. ($1=102.2250 Japanese yen) (Editing by Christopher Cushing, William Mallard and Greg Mahlichh)