Japan's financial sector is gradually recovering, thanks to the progress banks have made in dealing with asset quality issues and the prospect of better economic conditions. But recovery in the industry is expected to be slow at best, Standard & Poor's said Tuesday.

The downward trend in banks' credit ratings appears to have stabilized and the outlooks on the ratings of six Japanese banks have recently been revised to stable or positive from negative. In addition, the ratings of two other banks have been placed on Credit Watch with positive implications, the U.S. credit-rating agency said.

In the past year, 13 of the top 16 banks in Japan have announced either mergers or comprehensive alliances with other banks, and this realignment should positively affect industry risk over the medium term by removing excess capacity, it said.

However, mergers and alliances themselves will not resolve the major issues facing Japanese banks, S&P said.

While banks have made progress in identifying problematic loan exposure and making adequate provisions against expected losses, their balance sheets still carry massive bad loans, which will constrain improvement in their financial profiles, it said.

The recent consolidation will create four of the world's top five banks, each with over $1 trillion in combined assets. Ratings of the banks will not be raised simply because of their increased size, however, S&P said.

Any upward revision in the ratings on Japanese banks will only come about if the banks' credit quality improves following a reduction of bad assets and market risks related to their large cross-shareholdings, it said.

Also requisite will be more diversified and higher earnings for the banks, underpinned by the consistent development of more sophisticated risk-management techniques, S&P said.