* Regulator enforces 10 million yen deposit protection cap
* Bank very small and seen an isolated case
* Central bank expects no impact on bank system stability
* Bank executives were arrested over audit scandal in June (Updates with court filing)
By Taiga Uranaka
TOKYO, Sept 10 (Reuters) - The Incubator Bank of Japan, an unlisted lender specialising in small business loans, filed for bankruptcy protection on Friday, marking the first Japanese bank failure where regulators will let some depositors go out of pocket.
Japan's central bank said it expected no adverse impact on the country's banking system from Incubator Bank, a very small player in the financial sector and the first domestic bank to collapse since 2003. Financial markets took the news in stride.
Incubator Bank has been in difficulties since June, when authorities raided the company and later arrested top executives on suspicion of sabotaging a regulatory audit.
Deposits of up to 10 million yen ($119,200) will be protected under Japan's deposit insurance scheme. That is a departure from the past when regulators protected deposits in full because they thought not doing so could disrupt the financial system.
Banking Minister Shozaburo Jimi said Incubator Bank was an isolated case with unusual business practices that included buying up consumer loans and lending focused on a small group of companies.
"This bank is very unusual, and there won't be any impact on small regional banks or other financial institutions," Jimi told a news conference.
Incubator Bank had about 590 billion yen ($7 billion) in total deposits with 113,000 clients as of the end of August, and of that roughly 10 billion yen is unprotected by deposit insurance, the Financial Services Agency (FSA) said.
In contrast, Japan's top lender, Mitsubishi UFJ Financial Group has about 120 trillion yen in total deposits.
Incubator Bank was established in 2004, led by Takeshi Kimura, a former Bank of Japan official and who also once served as an adviser to the FSA. Kimura resigned from the bank in May, and was arrested in July along with three other bank officials and another former bank executive.
For the three months ended in June, the bank posted a net loss of 216 billion yen and liabilities exceeded assets by 187 billion yen, the FSA said.
Its failure comes as small banks continue to collapse at a rapid rate in the United States -- with 108 failures in the January-July period.
Incubator Bank has 118 branches throughout Japan and employs about 550 people. (Writing by Isabel Reynolds; Editing by Edwina Gibbs and Chris Gallagher)