The central bank said it will introduce a special deposit facility under which it will pay 0.1% interest on current account balances held by regional lenders that meet certain criteria. Interest rates are mostly flat or negative in Japan.
"The business environment surrounding regional financial institutions is becoming more severe due to the impact from the coronavirus pandemic, structural factors like dwindling population and continued low interest rates," the BOJ said.
"The BOJ decided to create a system that assists financial institutions in making efforts to underpin their regional economies," it said.
Under the three-year scheme lasting until March 2023, regional lenders that opt for mergers or business integration will be remunerated, the BOJ said in a statement.
Regional lenders that also improve their financial health such as by cutting operating costs will also be applicable for the scheme, it said.
The move reflects a growing concern, shared even by some BOJ policymakers, over the rising cost and diminishing returns of its ultra-loose monetary policy.
Under a policy dubbed yield curve control (YCC), the BOJ guides short-term rates at -0.1% and long-term yields at zero as part of efforts to revitalise the economy.
The policy, however, has added to strains for regional banks.
Prime Minister Yoshihide Suga has said there were too many regional banks in Japan, signalling his desire for some weak lenders to consider mergers or consolidation.
Even before the BOJ's latest move, some regional banks had already started the groundwork for consolidation.
Resona Holdings Inc said on Tuesday it would pay up to 66.1 billion yen ($630 million) to take full control of Kansai Mirai Financial Group.
(Reporting by Kaori Kaneko and Leika Kihara; Editing by Christopher Cushing and Muralikumar Anantharaman)
By Kaori Kaneko and Leika Kihara