Two of Japan's biggest financial institutions on Friday announced plans to merge and create the world's largest bank, the latest sign of recovery in the country's long-troubled banking sector.

The merger of Mitsubishi Tokyo Financial Group Inc., Japan's second-largest bank, with UFJ Holdings Inc., the fourth-biggest and one of the country's more troubled financial institutions, would create a bank with $1.7 trillion in assets. That would outstrip the country's current leader, Mizuho Financial Group Inc., and the global leader, Citigroup Inc. The newly forged company would have nearly 80,000 employees and more than 1,000 branches around the world.

The details of the planned merger remain under negotiation, officials from the two banks said at a news conference Friday evening. Earlier the banks notified the Tokyo Stock Exchange that they hope to have a preliminary deal by the end of the month, completing the merger by September 2005.

If the deal goes through, Japan's financial system would be dominated by three vast conglomerates: the combined UFJ-Mitsubishi group; Mizuho; and the Sumitomo Mitsui Financial Group Inc.

Analysts praised the proposed merger as a substantial step forward in efforts to cleanse Japan's banks of bad loans estimated to exceed $500 billion -- the legacy of the collapse of Japan's real estate market in the early 1990s and a cultural aversion to failure that has kept credit flowing to many insolvent companies.

Some economists have long feared that the bad debts choking Japan's banks could trigger a financial meltdown in the world's second-largest economy, sowing crisis around the globe. Consolidation has been seen as a key means of averting crisis by combining troubled lenders with institutions whose books are in stronger shape.

"This should remove any lingering doubts about the stability of the financial system," Richard Jerram, an economist at ING in Tokyo, said in a report circulated this week. "In terms of ending fears of financial system crisis, this is probably not the beginning of the end, but the final step."

Prime Minister Junichiro Koizumi and his economic policy minister, Heizo Takenaka, have said cleanup of the banking system is among their top policy goals. They have pressured lenders to cut credit to insolvent companies, with Takenaka famously declaring that under his reign no company would be deemed too big to fail. Takenaka has vowed to cut in half the amount of bad loans held by major Japanese banks by next March.

UFJ, Japan's most deeply indebted bank, faces possible criminal prosecution from regulators for trying to conceal the full extent of its $36 billion in bad loans. The bank declared losses of $3.7 billion for the fiscal year that ended in March. Mitsubishi Tokyo, on the other hand, is widely seen as one of the stronger banks. As of the end of March, only about 3 percent of the loans on its books were classified as bad, compared with nearly 10 percent of UFJ's debts.

Mitsubishi Tokyo has long resisted pressure from the government to take on a weaker partner. But the banks dismissed speculation that the merger amounted to a government-orchestrated shotgun wedding. Mitsubishi Tokyo Chairman Shigemitsu Miki told reporters that the merger was his idea, one he advanced during a meeting with top UFJ officials at the end of May.

The banks said the deal would be a good strategic fit. Mitsubishi Tokyo has a strong base of corporate clients and substantial international presence but relatively weak retail operations in Japan. UFJ has a large presence among small- and medium-sized businesses.

For UFJ, the deal would amount to a rescue, said Yukiko Ohara, banking analyst at Credit Suisse First Boston in Tokyo. The bank had been left with a choice of either being bought or accepting a publicly funded bailout, she said. A bailout almost surely would have entailed government requirements to lay off managers and cut lending to favored customers.

One consequence of the merger would be renewed attention to UFJ's relationships with its biggest borrowers, especially ailing retail chain Daiei Inc., whose flirtations with bankruptcy have become something of a bellwether for the health of corporate Japan and the government's resolve in allowing failed companies to die.

Analysts said Mistubishi Tokyo may demand that UFJ quickly minimize its exposure to Daiei, perhaps by shedding some of the loans and handing them off to the Industrial Revitalization Corp., a state-funded institution charged with reviving ailing firms.

Despite Mitsubishi Tokyo's relative financial health, the merged entity would face skepticism about its combined balance sheet. As news of the merger spread, the credit rating agency Standard & Poor's put three banks that are part of the Mitsubishi Tokyo conglomerate on a watch list for a possible downgrade, citing a higher level of bad loans once it assumes UFJ's liabilities.

Goodman reported from Shanghai.

The merger of Mitsubishi Tokyo Financial Group Inc. with UFJ Holdings Inc. would create a bank with $1.7 trillion in assets.