Private equity firm Carlyle Group is in talks to sell its stake in Taiwan's Ta Chong Bank to Yuanta Financial in a deal worth up to T$37 billion ($1.25 billion), two sources familiar with the situation said.

Carlyle is exiting its five-year investment in the small and slow-growing Taiwanese bank in a share swap deal that will also give it a 7 percent stake in the fast-expanding Yuanta, owner of the island's biggest brokerage.

The equity firm and Ta Chong's other major shareholder, the bank's founding Chen family, would swap their combined holding of about 70 percent for Yuanta shares, the sources said on Friday, declining to be identified because the information is confidential.

"Carlyle is shifting to Yuanta from Ta Chong because Yuanta has bigger potential. Ta Chong's business scale is quite small and fixed," said Jack Huang, partner in charge at U.S. law firm Jones Day in Taiwan.

"Carlyle has been planning to exit Ta Chong for quite a while," said Huang, who specialises in mergers and acquisitions but is not involved in the Carlyle deal.

Carlyle and Yuanta declined to comment.

Ta Chong, which trails 20 other Taiwanese banks by assets, said in a statement to the island's stock exchange on Friday that its board had not signed any merger agreement with any financial institution.

The swap ratio has yet to be worked out. One Taipei-based analyst estimated the group will get one Yuanta share for every 1.34 shares in Ta Chong.

One of the sources said the deal would be based on a price of T$17 per Ta Chong share. That would be a 45 percent premium to the bank's closing price on Friday.

Shares in Ta Chong reversed early losses of as much as 3 percent to close up by the maximum allowed 7 percent at T$11.75 after the Reuters report. The broader market fell 2.6 percent. Shares of Yuanta dropped 3.47 percent.

Carlyle bought a 35 percent stake in Ta Chong in 2007 for T$21.5 billion.

Sources told Reuters in April that the private equity firm had hired J.P. Morgan to dispose of its holding, now around 40 percent, and had been trying to enlist other shareholders to sell a controlling stake.

Carlyle, like rival Longreach, had struggled to get the returns they wanted from their investments in the competitive and fragmented Taiwan banking market. The return on assets from banks in 2011 was 0.53 percent, the lowest among banks in Asia excluding Japan.

Longreach is looking to sell its holding in Taiwan's Entie Commercial Bank. A source told Reuters on Thursday that Longreach was looking for T$30 a share, which would value any deal at about $1.2 billion.

YUANTA LOOKS BACK HOME

One of the sources said the deal could be officially announced as soon as the end of this month.

"Most of the terms have been settled," said the other source. "The only things left to be worked out are Carlyle's financing needs and arranging a position for Ta Chong's chairman in the merged company."

Yuanta is increasing its exposure to Taiwan, its home market, as efforts to tap the Chinese market have not been productive due to the slow progress on cross-strait banking ties, an area that has lagged other business growth between the two political rivals.

Yuanta has cut staff at its Shanghai office and at some Hong Kong operations. It has yet to set up any China business of its own, but has a small fund operation in China acquired last year when it bought Taiwanese brokerage Polaris.

"Yuanta has given up its Greater China dream," said an analyst at a U.S. securities house, who cannot be identified due to company policy.

"But Yuanta is paying a high price for Ta Chong. Even though it's a tough trade, it can add strength to Yuanta's current mediocre banking business," said the analyst.

Acquiring Ta Chong would give it a Taiwan branch network to beef up its very small presence, while local media have reported Yuanta is also looking to buy either of the Taiwan insurance units of Canada's Manulife and New York Life, both of which are currently on sale.

It has also been linked with the acquisition of a small local broker.

J.P. Morgan and Barclays are advising Carlyle, while Morgan Stanley is advising Yuanta, said one of the sources.

Taiwan media have previously reported that Fubon Financial and Yuanta were interested in buying Ta Chong.

This article is copyrighted by Reuters