* Earnings outlook battered as economy slows
* SMFG to buy small stake in S.Korea's KB Financial
* Bad loans mount (Adds details, confirmation of stake purchase in KB Financial)
By David Dolan
TOKYO, Oct 29 (Reuters) - Sumitomo Mitsui Financial Group (8316.T), Japan's No. 3 bank, slashed its full-year earnings target by 63 percent as a sputtering economy drives up its bad-loan costs and market turmoil erodes the value of its stock portfolio.
The bank, which earlier this year bought a 2 percent stake in Britian's Barclays (BARC.L), also said it will take up to the same amount in South Korea's KB Financial (105560.KS), in a deal estimated at 20 billion yen ($202 million).
Once thought to be relatively immune to the global credit crisis, Japanese lenders now face a sharp downturn in profits, largely due to their overexposure to the plunging domestic stock market.
They have also been waylaid by the brittle state of the world's no.2 economy, where a surge in bankruptcies has pushed bad loan costs sharply higher.
Sumitomo Mitsui is the first of Japan's top three "megabanks" to cut its forecasts for this business year. Analysts are expecting its two bigger rivals -- Mitsubishi UFJ and Mizuho Financial Group (8411.T) -- to follow suit.
"Generally speaking the numbers are bad in every line, but there's no real nasty surprise," said Kristine Li, banking analyst at KBC Securities in Tokyo.
Sumitomo Mitsui said it now expects net profit to total 180 billion yen ($1.8 billion) in the year to March 31, 2009, down from its original target of 480 billion yen.
That's 52 percent below the 403.1 billion yen average forecast in a poll of 12 analysts by Reuters Estimates.
Sumitomo Mitsui said it expects bad-loan costs to balloon to 370 billion yen ($3.7 billion) this year, up nearly three-fold from its original estimate.
Corporate bankruptcies jumped nearly 35 percent in September from a year earlier, rising for the fourth straight month, data from research firm Tokyo Shoko Research showed this month.
Property developers have been among the hardest hit, broken by the higher cost of raw materials.
Traditionally, Japanese banks hold large stakes in their corporate clients as a means to cement their business relationship. The value of those stocks -- estimated at $250 billion as of the end of March -- has been hit by the Tokyo stock market's drop to a 26-year low this year.
Unrealised losses on the bank's stock portfolio likely totalled 156 billion yen as of end-September. The damage to the profit-and-loss statement totalled 17 billion yen, the bank said.
Sumitomo Mitsui also said it buy up to a 2 percent stake in Korea's KB Financial, as it looks to step beyond its dwindling home market.
The acquisition, which is expected by mid-2009 at the earliest, is aimed at improving the Japanese lender's existing alliance with KB Financial affiliate Kookmin Bank, South Korea's leading lender.
The banks are likely to tie up in areas such as real estate finance and syndicated loans, Sumitomo Mitsui said.
While the stake is small, KBC's Li said she saw opportunities for Japanese banks in South Korea.
"I do think in the long-run Korea is a better market ... and I haven't seen any Japanese banks with presence in Korea."
Mitsubishi UFJ Financial Group (8306.T), Japan's biggest bank, earlier this week said it would raise as much as $10.6 billion to offset stock losses and a $9 billion investment in Morgan Stanley (MS.N).
Speculation has been growing that SMFG may have to raise fresh capital as well. The stock has lost more than half of its market value in the last month alone amid a broad equity market rout fueled by fears of a worldwide recession. (Additional reporting by Taro Fuse) (Editing by Kim Coghill)