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* Q3 net profit up 17 percent at 296.4 billion yen
* Profit helped by lower bad loan costs and share holdings sale
* But lower interest rates drive down lending income (Adds equity holdings sale)
By Taiga Uranaka
TOKYO, Feb 3 (Reuters) - Mitsubishi UFJ Financial Group (MUFG) on Friday posted a surprise year-on-year increase in profits for the three months to December, the first such rise in six quarters, helped by gains from its sale of corporate share holdings.
However, an ultra-low interest rate environment continued to drag on the lending business for MUFG - Japan's largest lender by assets - as well as that of other major banks in the country, all of which have posted lower net profits for the first nine months of the year ending March 2017.
Weak economic growth has stifled demand for corporate loans in Japan for years, and lenders were dealt another blow in early 2016 when the Bank of Japan turned to negative rates - a move aimed at defeating stubborn deflation but which has so far failed to encourage new borrowing.
The central bank has in fact recently cautioned that the prospects of hitting a 2 percent inflation target remained uncertain, indicating Japan's lenders were unlikely to see their fortunes improve anytime soon.
MUFG's third-quarter net profit rose 17 percent to 296.4 billion yen ($2.62 billion), versus two analysts' average estimate for an 11 percent drop, mainly because gains from its sale of equity holdings more than doubled to 52.1 billion yen. Its core lending activity, however, remained weak.
MUFG's domestic equity holdings stood at 6 trillion yen as of December 2016.
Japanese banks, as a traditional business practice, pick up small stakes in corporate clients. But MUFG and its rivals have been trying to cut these holdings in order to be less exposed to the volatility in stock markets. Stricter global bank capital regulations have also made it more costly to own stocks.
However, there are no signs of a pick up in banks' lending business either. MUFG reported a net interest income of 495.2 billion yen for the third quarter, versus 519.6 billion yen a year ago. Japan's No.2 lender by assets, Mizuho Financial Group , posted a 13 percent drop in net interest income for the period.
"Looking forward, for Q4, attention is on how much loan loss provisions banks will set aside for troubled borrowers like Toshiba and how much losses they will book for their holdings in Treasuries as U.S. interest rates have risen sharply," said a banking sector analyst with a European brokerage, who did not want to be named as he was not authorised to talk to media.
Average interest rates on outstanding loans held by Japanese banks fell to a record low of 1.009 percent in November, latest Bank of Japan data shows.
For the full-year through March, MUFG reiterated its net profit forecast at 850 billion yen, down 10.7 percent from a year ago. Seventeen analysts on an average expect 923.1 billion yen, Thomson Reuters data shows.
MUFG owns Thailand's fifth-largest lender Bank of Ayudhya Pcl and is the biggest shareholder in Morgan Stanley with a 20 percent stake.
Mizuho and Sumitomo Mitsui Financial Group, Japan's third-largest lender, have also reported lower profits and weak lending for the nine months to December 2016. ($1 = 113.0700 yen) (Reporting by Taiga Uranaka; Editing by Himani Sarkar)