Can we use a Merkle Tree structure to reduce digest size?
The problem is that your construction (the whole second picture) still constitutes a compressing function with 128bit output. Hence, we can find collisions at complexity about $t\cdot2^{64}$, where t is the runtime of your construction.
Indeed, it seems that a little misconception motivates your work: You sound as if it was harder to find a collision than a second-preimage. However, it is the other way around; finding a second-preimage is (generically) a lot harder than collision-finding. The complexity of a generic second-preimage attack is equal to that of a generic preimage attack. The complexity of a generic collision attack is only the square root of the complexity of a second-preimage or preimage attack.