UPDATE 4-Shinsei to buy Aozora to create Japan No.6 bank

* Loss-making Shinsei, Aozora to create No.6 Japan bank

* Merged bank may take more government bail-out money

* Analyst: Questions remain about long-term strategy

* Shinsei, Aozora shares up 1.3 pct

(Recasts, adds details)

By David Dolan

TOKYO, July 1 (Reuters) - Japan's Shinsei Bank (8303.T) is to buy smaller Aozora Bank (8304.T) to create the country's sixth-largest lender, hoping the two loss-makers can together return to growth in both retail and corporate banking, the banks said in a joint statement.

Aozora, majority owned by Cerberus Capital Management [CBS.UL] is worth about $2.6 billion, while Shinsei, about one-third owned by buyout firm JC Flowers and Co, has a market value of $3.3 billion.

Together they will have assets of 18 trillion yen ($185.8 billion) and rank above Chuo Mitsui Trust Holdings (8309.T), currently Japan's No.6 bank.

The merged entity could also apply for further help from the government. Japan pumped about 621 billion yen into the two lenders during the 1990s banking crisis. Both banks were nationalised and later sold to U.S. funds.

"If we think it's necessary we would apply for public money," Norito Ikeda, the former head of a regional lender, who has been picked to run the new bank, told a news conference.

Shinsei would take a 58 percent stake in the new bank, based on Reuters' calculations using common shares, but not treasury shares.

The ownership ratio would be close to fifty-fifty once all of Aozora's convertible preferred shares are converted to common stock, a spokesman for Shinsei said.

The combined bank would have a Tier 1 capital ratio of 8 percent as of the end of March.

Analysts have said the deal gives Shinsei much-needed capital and access to Aozora's long-standing relationships with Japan's regional banks. However, they have said the prospects for growth in domestic lending -- where competition is fierce -- may be negligible.

"The merger is on balance positive, but there are a number of question marks about current-year profit and the strategic direction of the new group over the longer term," said Jason Rogers, a credit analyst at Barclays Capital in Singapore.

SHAREHOLDER APPROVAL

The deal, which is to be completed by October next year, has the backing of both JC Flowers and Cerberus, the banks said. Domestic media had previously reported that negotiations had been sidelined by disagreements between the top shareholders.

JC Flowers could eventually exit the investment at some point following the completion of the deal, Shinsei President Masamoto Yashiro told a news conference.

Yashiro and Aozora President Brian Prince -- himself a former Shinsei executive -- will chair an "integration committee" that will help decide on the new bank's strategy. Ikeda, who will take over the combined unit, will act as an advisor, the banks said.

The new name of the lender has yet to be decided, they said.

The increased scale will help the new lender compete against Japan's "megabanks" and scores of regional lenders, Shinsei and Aozora said.

But that is likely to be a tough battle, especially against massive lenders such as Mitsubishi UFJ Financial Group (8306.T) and Sumitomo Mitsui Financial Group (8316.T).

Ratings agency Fitch Ratings has said that a tie-up may not improve the banks' business models or immediately increase earnings power.

Shinsei has focused on retail banking and consumer finance while Aozora has concentrated on corporate finance and real estate, meaning there may be little room for gaining economies of scale, Fitch said.

After being sold by the government after the banking crisis, both banks struggled to carve a niche for themselves in the domestic market, eventually turning to overseas investments.

In the last financial year the two lost a combined 385.6 billion yen.

Those losses have prompted Japanese media to criticise the banks, and their American owners, for making high-risk bets while still owing taxpayer money.

The two banks still owe the government 396 billion yen.

Shares of both Shinsei and Aozora closed up 1.3 percent ahead of the announcement. ($1=96.81 Yen) (Additional reporting by Mayumi Negishi and Taro Fuse; Editing by Mike Nesbit)