UPDATE 2-Citigroup seeks to exit Japanese retail banking - source
* Citi Japan has struggled with compliance issues, achieving scale
* Citi had among the smallest of comparably sized banks' loan books
* Japanese banking faces weak domestic loan demand (Recasts with details on Citigroup's past compliance, cost problems)
TOKYO, Aug 20 (Reuters) - Citigroup Inc is preparing to sell its Japanese retail banking operations, a source with direct knowledge of the matter said on Wednesday, as it waves the white flag on a venture plagued by regulatory troubles and anaemic lending.
The company which pioneered 24-hour ATMs in Japan and was the only foreign bank to make a major push into its retail banking sector is throwing in the towel after failing to gain enough scale to justify its costs.
Citigroup has also signalled a desire to refocus its overseas strategy on growth markets and away from saturated mature markets such as Japan, where it has been doing business for more than a century.
Citi has approached Japan's top three lenders, Mitsubishi UFJ Financial Group (MUFG), Mizuho Financial Group and Sumitomo Mitsui Financial Group (SMFG) about a sale, as well as regional banks, said the source, who was not authorised to discuss the matter publicly.
A Citigroup spokesman declined to comment. Representatives at MUFG and Mizuho also declined to comment while a representative at SMFG was not immediately available.
The U.S. bank will keep corporate and investment banking and trading businesses in Japan, the source added.
Industry officials say it may be difficult to find a buyer for a modest retail banking operation with weak loan demand and falling interest margins, and which has had regular run-ins with regulators.
"The company has been penalised three times by regulators so there are issues with compliance that would make us cautious," a senior financial industry executive said. He asked not to be named because of the sensitivity of the matter.
LAGGING IN LOANS
Citigroup had 33 retail branches and 3.6 trillion yen ($35 billion) in deposits as of end-March, ranking 30th among 64 top-tier regional banks in Japan. But its loan book, with an outstanding balance of 356.2 billion yen, was near the bottom of the list.
For the latest year to end-March it posted a 1.3 billion yen net profit on revenue of 68.3 billion yen.
Lending has been sluggish in Japan overall, as corporations sitting on massive amounts of cash are reluctant to borrow or invest aggressively with domestic growth prospects looking limited, while dull wage growth has left households cautious about spending.
Citibank Japan's deposits are split about evenly between yen- and foreign currency-denominated funds, according to one source close to the bank who was not authorised to speak with the media.
While it offers domestic mortgages and loans, its main appeal to customers has been global services such as local currency withdrawals from overseas ATMs, industry officials say.
Prospects for a sale could be dampened by worries that customers would flee if their deposits changed hands to a Japanese lender and they lost access to Citi's global banking network.
A source with direct knowledge of Citi's management said the bank may need to offer a sweetener to attract buyers, such as allowing customers continued access to overseas banking.
The bank has also faced persistent compliance problems. It was penalised three times by regulators from 2004 to 2011 over inadequate monitoring of transactions under anti-money laundering rules and insufficient disclosure of risks in marketing financial products.
After the latest regulatory action in December 2011, which resulted in a one-month suspension of financial product sales, the unit tapped former Sumitomo Mitsui Banking Corp executive Kazuya Jono to become Citibank Japan CEO in June 2012.
Jono was replaced in June of this year by Peter Eliot, CEO of Citigroup Japan Holdings Corp. (1 US dollar = 102.9300 Japanese yen) (Additional reporting by Taro Fuse, Takahiko Wada and Emi Emoto in Tokyo, and David Henry in New York; Editing by Edmund Klamann, Jan Paschal and Stephen Coates)