DUBAI, May 23 (Reuters) - Bahrain's Al Salam Bank SALAM.BH and BMI Bank, an affiliate of Oman's Bank Muscat BMAO.OM , have announced plans to merge, a tie-up which would create the kingdom's third-largest bank by assets, the lenders said in a statement.

A committee has been created by the two banks to administer the merger process, which would create a bank with assets of around 1.7 billion dinars ($4.5 billion). The merger will involve a share swap, with the final ratio yet to be decided, a separate statement from Bank Muscat said.

The proposed merger, which has the assent of both boards but still needs shareholder and regulatory approval, is the latest example of consolidation in the Bahraini banking system.

Mergers among Bahraini lenders have been encouraged by the country's central bank, especially among smaller Islamic banks hit hard by a local real estate crisis and political uprisings in the tiny Island nation.

Previous attempts to consolidate in the Gulf Arab region's banking sector have been scuppered with shareholders unwilling to cede control except for sky-high valuations.

Al Salam Bank had previously tried to merge with Bahrain Islamic Bank BISB.BH (BIsB) but that deal collapsed in February 2012 over valuation disagreements.

National Bank of Bahrain NATB.BH and a local pension fund said in March it would buy a 51.6-percent stake in BIsB, and Capivest, Elaf Bank and Capital Management House completed a three-way merging in January. ID:nL6N0C20AK ID:nL5E9C7737 ?

"Consolidation was the only way forward for Bahraini banks to stay competitive and financially strong in the aftermath of the recent financial crisis and resulting economic downturn," said Al Salam and BMI in a joint statement on Thursday.

BMI Bank is 49-percent owned by Bank Muscat and talks will include what role the Omani lender will play in the new entity, according to one senior Bahraini banker, with a full exit a possible option. ($1 = 0.3770 Bahraini dinars)

(Reporting by David French; Editing by Dinesh Nair)

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Keywords: BAHRAIN ALSALAM/MERGER