* Banks benefit from report seeing higher earnings * Retail investors trade volatile smaller stocks - trader * KDDI lifts full-year earnings forecast * HSBC cuts Japan rating, BNP sees index rising to 13,000 By Ayai Tomisawa TOKYO, Jan 29 (Reuters) - The Nikkei share average edged up on Tuesday as investors welcomed a newspaper report that major banks were likely to have significantly larger profits this year, while small caps such as bio-chemical stocks attracted retail investors. Investors have been piling into the Japanese market in the hope that "Abenomics", Prime Minister Shinzo Abe's brand of economic policy involving aggressive monetary easing and a weaker yen, will boost exporters, financials and real estate. Sumitomo Mitsui Financial Group (SMFG), Mizuho Financial Group and Mitsubishi UFJ Financial Group (MUFG) rose between 2.9 and 4.4 percent after the Nikkei newspaper said the recent stock rally would boost the value of banks' own shareholdings and their net profit in the current fiscal year. The banks were three of the four most-traded stocks by turnover on the main board. "Everyone has been speculating on who will benefit from Abenomics, and banks were one of the candidates. Hearing that they will actually see those benefits is a big positive for the market," said Tetsuro Ii, chief executive of Commons Asset Management. The Nikkei rose 0.4 percent to close at 10,866.72, or 1.2 percent below a 32-month high of 11,002.86 reached on Monday. Market players said that investors have started looking into sectors outside of exporters as there's been a pause in the trend of the yen weakening. They pointed to the heat around small and mid-sized stocks, which market watchers say retail investors have been piling into, partly because of credit deregulation starting in January that enabled them to use the same collateral for multiple margin trades in the same day. "When the currency moves are not serving as a big catalyst, investors trade on volatile stocks hoping to secure gains from margins," said Mitsushige Akino, general manager of investment department at Ichiyoshi Asset Management. Such small caps as biotech companies were in demand from retail investors. Japan Tissue Engineering Co surged as much as 26 percent during the day before ending up 4.5 percent while DNA Chip Research Inc jumped 17 percent. "These stocks can offer sharp gains through active price movements... And when the yen weakens again, they are quick to sell these stocks and add more exporters," Akino said. Some investors are turning their eyes to earnings reports that have started for the October-December quarter. Companies reporting their results this week include Sumitomo Mitsui Financial Group, NTT Docomo Inc, Toshiba Corp and Honda Motor Co. KDDI Corp gained 2.8 percent after the mobile phone operator lifted its full-year forecast by 1 percent to 505 billion yen ($5.57 billion) on increased contracts for smartphones. "I think earnings are going to be pretty weak (for the period), but most companies are going to get ignored as most people are looking forward to improvements in the yen," said a hedge fund manager. The yen has slid around 10 percent over the past two months, a trend that boosts exporters once their overseas revenue is repatriated. On Tuesday, the currency firmed to 90.76 against the dollar from the previous day's high of 91.26. Maeda Corp tumbled 13 percent after the contractor forecast an operating loss of 7 billion yen for the year ending March, down from a previous estimate of 5.2 billion yen profit, citing the increased cost of construction materials. MIXED FEELINGS "The two factors to watch now are whether foreign investors, who drove the recent rally, remain bullish and continue buying, and whether retail investors continue to buy into emerging stocks that are relatively immune to the exchange rate," said Yoshihiro Ito, chief strategist at Okasan Online Securities. Foreign banks have mixed view of the outlook for the Japanese market. While BNP Paribas has raised its target for the Nikkei to 13,000, or nearly 20 percent higher than its current level, HSBC shifted Japan back to "underweight" in its global stocks portfolio after raising it to neutral in December. "We feel the excitement over 'Abenomics' is now priced in, and the Bank of Japan has yet again shown it will do nothing dramatic to end deflation, Garry Evans, global head of equity strategy at HSBC, said in a note on Monday. The BOJ announced a 2 percent inflation target at its last policy meeting on Jan. 22 and committed to open-ended buying of assets, but only from 2014, which disappointed some investors hoping for more immediate action. The broader Topix gained 0.8 percent to 920.76, with 3.47 billion shares changing hands, the same level with last week's average daily volume of 3.44 billion shares.