* ICBC interested in about 20 pct of Cathay Fin- source
* At current market cap, deal would be worth $3.4 billion
* Sign of easing of cross-strait relations
* Companies hope to sign deal soon after free trade pact
* ICBC shares close up 0.6 pct, Cathay ends flat before news (Adds quotes, background, details)
By Faith Hung and Michael Flaherty
TAIPEI/HONG KONG, Dec 2 (Reuters) - China's ICBC (1398.HK) is in talks to buy a stake in Taiwan's Cathay Financial (2882.TW), sources said on Wednesday, in a potential $3.4 billion deal that would be the first direct investment by a Chinese bank into a Taiwan financial group.
The talks come amid improving relations between former enemies China and Taiwan, and a flurry of activity involving financial groups and investors on both sides of the Taiwan Strait.
Any deal between the two companies would face both financial and political scrutiny, with tensions still lingering despite a recent China-Taiwan memorandum of understanding for financial companies that's meant to boost economic and political ties.
One source with direct knowledge of the matter said that ICBC, the world's largest bank with a market capitalisation of $265 billion, was interested in buying a roughly 20 percent stake in Cathay Financial, Taiwan's top listed financial holding group, with a market value of $17.3 billion.
"The two firms have met for five to six times in the past two months. The talks are getting very serious," said the source.
Another source confirmed the talks and the potential size of the deal but said discussions were in their early stages. ICBC and Cathay Financial declined to comment.
The sources did not want to be identified because they were not authorised to speak publicly about the deal.
"This will definitely be positive for Cathay Financial because it gives them a huge advantage if they want to expand in China," said Michael Lan, an analyst at Fubon Securities.
He added that for now, it will be tough for Chinese banks to be anything but investors in Taiwan as the Taiwanese banking market is oversaturated.
But Chinese lenders may still seek to open branches in Taiwan, a desire that China Construction Bank (601939.SS) spoke of on Wednesday [ID:nPEK205409].
Once on the brink of war, China-Taiwan trade relations have thawed since President Ma Ying-jeou took office last year, with bilateral deals promoting tourism and shipping links already concluded.
ICBC and Cathay hope to sign a deal soon after Taiwan and China sign a free trade pact, which Taiwan aims to sign early next year, one of the sources said.
Any plan for ICBC to buy into Cathay Financial will likely catch the attention of pro-independence Taiwan lawmakers who have already complained about Beijing's economic support to Taiwan with the goal to eventually unify the island with Beijing.
ICBC shares closed up 0.6 percent in Hong Kong, while Cathay shares ended down 0.2 percent in Taipei. The initial Reuters report about the talks broke after Taiwan's market closed.
"An acquisition makes lots of sense for ICBC and Cathay Financial," said an analyst at a U.S. brokerage in Taiwan, who was not authorised to speak publicly about the matter.
"ICBC could own part of Taiwan's biggest financial holding firm. And Cathay can leverage ICBC's distribution network in China for its insurance products."
Cathay Financial is the parent of Taiwan's largest insurer.
The talks between ICBC and Cathay are the latest in a flurry of activity among financial groups in Greater China.
Hong Kong-based Primus Financial Holdings, picked by AIG (AIG.N) as the buyer for its Taiwan Nan Shan Life unit, said on Wednesday it intends to resubmit its application to Taiwan regulators seeking approval for the $2.15 billion deal. [ID:nHKG182972]
And Fubon Financial (2881.TW), Taiwan's No. 5 financial conglomerate, is one of a number of parties bidding for Morgan Stanley's (MS.N) stake in Chinese investment bank CICC, sources with the direct knowledge of the bid said, a deal that could be worth more than $1 billion. [ID:nHKG180237]
Cathay Financial Group was established in 2001. The company's units include life insurance arm, a securities brokerage, a bank and other financial institutions.
ICBC was founded in 1984 by the Chinese government with the aim to take over responsibilities from China's central bank to support state-owned enterprises across the Communist nation.
Roughly five years ago, ICBC was bailed out by the Chinese government. By 2006, it went public through successful IPO offerings in Hong Kong and Shanghai, becoming the largest bank in the world after last year's financial crisis.
ICBC bought a 20 percent stake in South Africa's Standard Bank (SBKJ.J) for $5.6 billion in cash in 2007, at the time the largest ever foreign acquisition by a Chinese commercial bank. (Additional reporting by Baker Li, Kelvin Soh, Lee Chyen Yee and George Chen; Editing by Jean Yoon) ((firstname.lastname@example.org; +852 2843 6540; If you have a query or comment on this story, send an email to email@example.com))