Daiwa Securities Group could pay around $2 billion to exit an investment banking joint venture with Sumitomo Mitsui Financial Group, sources said, triggering a further shake-up of Japan's banking industry.

Shares of Daiwa, Japan's No.2 brokerage, tumbled 5 percent amid concerns it could lose clients to SMFG, the country's third-largest bank. SMFG slipped 0.3 percent, reflecting worries over how it will fill strategic holes created by the split.

The fate of the partnership has been in doubt since SMFG agreed earlier this year to buy Citigroup's brokerage and securities underwriting operations in Japan for about $6 billion, some of which overlapped with the Daiwa venture.

That deal came on the heels of Nomura's purchase of parts of Lehman Brothers, and Mitsubishi UFJ Financial Group's investment in Morgan Stanley, as Japanese banks looked to take advantage of a global financial crisis that sidelined Wall Street rivals.

SMFG had been in talks with Daiwa to take a majority stake in the 10-year old venture and combine its wholesale operations with those bought from Citigroup, but Daiwa was loath to lose control and the negotiations fell through.

Daiwa owns 60 percent of the unlisted venture, Daiwa Securities SMBC, and SMFG the rest.

It's been 10 years since the venture was born. The financial environment has changed and we felt the structure of the alliance between the bank and brokerage should also change. But we couldn't reach an agreement, said a senior executive at SMFG.

SMFG said it was in talks with Daiwa but had made no decision. Daiwa declined to comment.

One source, speaking on condition of anonymity as no decision on the talks was yet public, said Daiwa Securities will likely have to pay about 200 billion yen ($2.2 billion) to buy SMFG's 40 percent stake. Two other sources familiar with the issue said the venture partners were discussing ending the tie-up.

Daiwa's stock fall reflected investor worries the broker would lose some clients to SMFG, which will build its wholesale securities business around broker Nikko Cordial and parts of investment bank Nikko Citigroup it is set to buy from Citigroup.

Daiwa has been depending on Sumitomo Mitsui a lot to win mandates for various businesses and now it is going to lose that tie. Daiwa SMBC played a key role for Daiwa Securities Group, said Wataru Kasatani, a financial analyst for MDAM Asset Management in Tokyo.

KEEPING TIES

Sumitomo Mitsui will continue to serve as Daiwa's main lender and the two plan to retain other ties, the sources said.

But the loss of the investment banking alliance with Daiwa will create hurdles for SMFG as it aims to catch up with Nomura, the leading underwriter in Japan, and use Nikko Citigroup and ties forged with Citigroup to expand overseas.

Daiwa Securities SMBC ranked second in underwriting stock issues by Japanese companies in the six months through June, according to Thomson Reuters data. It ranked third in corporate bonds behind Nomura and Mitsubishi UFJ Financial Group.

Nomura is expanding its operations after buying the Asia, Europe and Middle East operations of Lehman last year while Mitsubishi UFJ Financial Group and Morgan Stanley plan to merge their investment banking business in Japan.

SMFG now faces the challenge of filling holes in its investment banking operation that have been left by ending its partnership with Daiwa, said Credit Suisse analyst Shinichi Ina.

Meanwhile Daiwa has been building up its overseas network to expand its mergers and acquisition advisory businesses.

Daiwa Securities SMBC, which already has an alliance with U.S. advisory firm Sagent Advisors, in May agreed to buy the corporate finance unit of Britain's Close Brothers Group for 75 million pounds.

(Additional reporting by Anurag Kotoky in Bangalore, Yumiko Nishitani, Junko Fujita and Nathan Layne in Tokyo; Editing by Ian Geoghegan)

Japan Investment Morgan Stanley Citigroup