"Thinking long term, population decline is the biggest challenge," said Masaaki Tani, chairman of the Regional Banks Association of Japan, which represents 64 of the 100 regional institutions.

"Especially for local lenders like us, this means - to put it in extreme terms - there will be no place for our activities," Tani, president and chairman of Fukuoka Financial Group (>> Fukuoka Financial Group, Inc.), the biggest regional bank, told Reuters in an interview.

"One of the options is consolidation. We need a certain scale of operations to take risks," said Tani, 71, whose region of the westernmost main island of Kyushu is stereotyped for its swagger. "A bank too small to take risks cannot contribute to the local economy."

Japan's bank regulator, cognisant of the country's stark demographics, has begun an unusually direct campaign to prod the regional banks - which together extend roughly half of Japan's $4 trillion outstanding bank loans - to consider mergers and acquisitions.

Regional banks are largely tied to the fortunes of their local prefectures. Aside from Tokyo, Osaka and a few others, the outlook for the working-age population - and thus the prospect for loan demand - is grim. To preempt a potentially rough future, or worse, bankruptcies or collapses due to low deposits or poor loan coverage, Tokyo is encouraging the ultra-conservative small banks to embrace change.

The head of the Financial Services Agency has directly pressed the banks to slim down through mergers or takeovers, and the FSA has set up meetings with regional bank presidents to grill them on their long-term business plans, according to people involved in the process.

BANKERS SLOW TO BUDGE

The agenda is implicit but clear, bankers and regulators say: show how you plan to survive over the coming decades as local economies wither, or look for tie-ups. Japan is the fastest-greying industrial power, and populations outside big cities like Tokyo and Osaka are ebbing even faster as young people head for the cities and the ranks of the remaining elderly swell.

But regional banks have so far shown little interest in buying, or being bought by, their peers. For many regional bank chiefs, heavyweights in their local business circles, the prospect of relinquishing control of their banks is unattractive when they are enjoying strong profits - at least for now.

Net profits at tier-one regional banks jumped 50 percent in the six months through September, industry data show, but this was largely a windfall from lower credit costs and stock-related profits. Loan income fell 4 percent, as demand remains tepid.

Regional lenders, unlike the "megabanks" such as Mitsubishi UFJ Financial Group (>> Mitsubishi UFJ Financial Group Inc), cannot easily tap overseas markets to offset sluggish growth at home.

Tani acknowledged that smaller banks have been slow to respond to the changing times but said the regional banks are beginning to consider strategies to survive and thrive in the future. "The point is when they will make their decisions."

Tani has first-hand experience of managing the transition after mergers from his time as a senior banker in a regional bank. He oversaw the 2007 acquisition by the Bank of Fukuoka, which he joined in 1966, of two smaller rivals to become Fukuoka Financial, overtaking the Bank of Yokohama (>> The Bank of Yokohama, Ltd.) to become the biggest regional bank, with 13.8 trillion yen ($134 billion) in assets.

WINNERS AND LOSERS

Japan's biggest banks have already experienced wrenching consolidation: 23 lenders melded into today's four major banking groups over the 15 years of post-bubble economic and financial crisis through 2005. Regional banks have largely been spared the knife so far.

Tani declined to speculate on what the looming industry shakeout might look like, but investors are already dividing up the regional banks.

The best performer of the Shinzo Abe era, Reuters data show, is the Bank of Kochi (>> Bank of Kochi Ltd), in Japan's southwest. Its shares have surged 88 percent since mid-November 2012, when Abe became the presumptive favourite to win election as prime minister with his reflationary policies.

The Topix banking index <.IBNKS.T>, comprising regional and megabanks, had risen 62 percent during the same period, while the benchmark Nikkei average is up 71 percent.

Also beating the broader market are North Pacific Bank (>> North Pacific Bank Ltd), Suruga Bank (>> Suruga Bank Ltd.), Yachiyo Bank (>> Yachiyo Bank Ltd) and Fukushima Bank (>> THE FUKUSHIMA BANK, LTD.).

The most battered regional lender, Nanto Bank (>> The Nanto Bank, Ltd.), has fallen 8 percent in the Abe era, while Ogaki Kyoritsu Bank (>> The Ogaki Kyoritsu Bank, Ltd.) and Senshu Ikeda Holdings (>> Senshu Ikeda Holdings Inc) are also down for the period. The next-worst performers are Shiga Bank (>> THE SHIGA BANK, LTD.) and Chukyo Bank (>> Chukyo Bank Ltd), each up about 1 percent.

Tani's Fukuoka Financial is up 44 percent, in the top half of the bank sector but well behind the broader market. Its core Bank of Fukuoka unit had loans worth 83.37 percent of deposits for the six months through September, above the 70.6 percent average for first-tier regional banks.

(Additional reporting by Dominic Lau; Editing by William Mallard & Shri Navaratnam)

By Taiga Uranaka and Taro Fuse