By Tom Arnold and Saeed Azhar

DUBAI, April 25 (Reuters) - Saudi lenders Alawwal Bank and Saudi British Bank have agreed to start talks about a merger that could create the kingdom's third biggest bank with assets of nearly $80 billion.

The announcement by the lenders on Tuesday is the latest example of consolidation in the Gulf's banking sector, where profit margins are being squeezed by lower government and consumer spending because of weak oil prices.

"The consolidation points to the fact that you need stronger banks to sustain in this challenging macro environment. You need large, efficient banks to serve," said Murad Ansari, an analyst at EFG-Hermes in Saudi Arabia.

British banks are the biggest shareholders in both lenders. Royal Bank of Scotland RBS.L acquired a 40 percent stake in Alawwal Bank when it bought ABN AMRO in 2007. RBS has been trying sell the holding for a number of years as it retreats from international operations.

HSBC Holdings owns 40 percent of Saudi British Bank (SABB), which is the kingdom's sixth largest bank by assets.

A combination of Alawwal and SABB would rank third in Saudia Arabia with assets of $77.6, behind National Commercial Bank and Al Rajhi Bank, according to Thomson Reuters data.

Reuters reported in November that RBS had hired Credit Suisse to sell its stake in Saudi Hollandi Bank, which was renamed Alawwal Bank in November.

Banking sources said at the time they expected the holding to go to a local rival, partly because of restrictions on a foreign buyer taking the stake.

The banks said on Tuesday that any merger agreement would be subject to a number of conditions, including the approval of the kingdom's regulatory authorities, and said Saudi's central bank had been consulted about merger requirements beforehand.

The two lenders have several common shareholders. Saudi's Olayan family holds 21.76 percent of Alawwal Bank and 16.98 percent in SABB while the Saudi government owns 10.50 percent of Alawwal Bank and 9.74 percent of SABB, according to Thomson Reuters data.

The two banks said the proposed merger, if completed, would not result in any forced layoffs.

The announcement came the same day Citigroup C.N obtained a licence to conduct capital markets business in Saudi Arabia, which will allow the U.S. bank to offer banking services after an absence from the kingdom of almost 13 years.

A total of 12 commercial lenders operate in the kingdom's banking sector, sharing total assets of more than 2 trillion riyals ($535 billion).

Banking consolidation is also underway elsewhere in the region. Abu Dhabi lenders First Gulf Bank (FGB) and National Bank of Abu Dhabi (NBAD) merged on April 1 to create one of the largest banks in the Middle East and Africa.

In Qatar, Masraf Al Rayan is moving ahead with a three-way merger with Barwa Bank and International Bank of Qatar. ($1 = 3.7503 riyals)

(Editing by David Clarke) ((; +97144536265; Reuters Messaging: