(Adds regulation lawyer quote)
By Thomas Atkins and Sarah White
FRANKFURT/MADRID, March 12 (Reuters) - European banksoperating in the United States face an expensive challenge tomeet tough standards set by regulators after both Santander and Deutsche Bank flunked a healthcheck andwere told to improve systems and controls.
Spain's Santander failed the Federal Reserve's "stress test"for the second consecutive year and Deutsche Bank failed at thefirst time of asking due to weaknesses in their capital planningprocesses.
The setback could limit dividend payments the U.S. arms canmake to parent groups. Its main impact is likely to be to force banks to beef up internal controls and risk identification andmanagement -- potentially spending hundreds of millions ofdollars to do so.
"This capital planning is not just for now, it's for thefuture. It's looking more at their sustainable business modeland over time how they define the process and make itdocumented," said Sven Ludwig, senior vice president of risk andanalytics for EMEA at software and technology services firmSunGard.
The failures will also fire warning shots across otherforeign banks which are expected to undergo the annualexamination in coming years, including Credit Suisse,Barclays and UBS.
U.S. regulators have toughened rules on overseas banks tomake sure their American operations have enough capital towithstand a problem there. The stress tests also aim to ensureforeign banks are as well-run as domestic ones.
Both Deutsche and Santander were already having problems intheir U.S. businesses, although both were deemed to hold enoughcapital by the Fed.
Deutsche Bank, which competes head-to-head on Wall Streetwith the likes of JP Morgan and Goldman Sachs, isinvesting $1 billion over four years to improve its U.S.internal reporting and controls.
Last year the New York Fed found serious problems in itsU.S. operations, including shoddy financial reporting, weaktechnology and inadequate auditing and oversight, sources havesaid.
The bank has hired 500 staff to address weaknesses in U.S.financial reporting, including Elizabeth Ford from Goldman Sachsas head of compliance in the Americas.
"It's a huge amount of regulation and it's very hard to beup to speed with all of that," said financial regulation lawyerPascal di Prima at Simmons & Simmons. "I don't think it would befair to say that Deutsche Bank failed because of improper riskmanagement."
Santander is trying to clean up its U.S. operations underone holding company, including centralising risk controls andsystems, but that could take several years. It inherited someproblems from Sovereign, which came under its control in 2009after a string of acquisitions.
New Santander boss Ana Botin has shaken up management thereand appointed former JPMorgan executive Scott Powell as CEO ofthe U.S. holding company two weeks ago.
Santander is spending about $170 million a year to addressthe issues and has hired about 500-600 people to deal withcompliance and risk management in the past 18 months.
"This clearly means that Santander Holdings USA still has alot of work to do and the progress achieved has been scarce,"analysts at Kepler Cheuvreux said in a note to clients.
The U.S. stress tests differ substantially from testscarried out by European regulators. The Fed assesses a bank'sfuture earnings, strategy and dividend plans and whether systemscan identify and prepare for risks - and will force lenders tochange if it doesn't like the plans. (Writing by Steve Slater; Editing by Vincent Baby)