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* Blow to government hopes of boosting competition
* Co-op blames worsening economic outlook, tougherregulation
* Co-op capital concerns had led to doubts over deal
* Lloyds now plans to spin off and sell shares in TSBbranches
By Matt Scuffham and Clare Hutchison
April 24 (Reuters) - The planned sale by state-backed Lloyds of hundreds of UK bank branches to the Co-op fellthrough on Wednesday, setting back government plans to boostcompetition in the industry.
The Co-op said it pulled out of the deal, worthup to 750 million pounds ($1.15 billion), due to tougheningregulations and the worsening outlook for UK economic growth.
Lloyds, which is Britain's biggest retail bank and has over2,900 branches in total, plans instead to spin-off the 630branches under the TSB name and sell shares in the new company.
UK lawmakers had hoped the deal would create a viablecompetitor to Britain's established but unpopular lenders, whichhave been plagued by scandals including the mis-selling ofinsurance on loans and mortgages.
Britain's finance ministry said the government remained"determined to promote greater competition in the banking sectorin order to provide consumers with more choice".
There was political support for the Co-op to play a biggerrole in UK banking because of the firm's ethical credentials.The Co-operative is Britain's biggest mutual business, owned notby private shareholders, but by over 6 million individuals.
However, industry sources had expressed doubts for severalmonths about the viability of the deal, mainly citing concernsabout how the Co-op would meet regulatory capital requirements.
Co-op chief executive Peter Marks said in a statement thatthe deal would not currently deliver a suitable return in areasonable timeframe and with an acceptable level of risk.
"This should serve as yet another warning to (financeminister) George Osborne that his economic plan is failing andhe must urgently act to kickstart our flatlining economy," saidChris Leslie, a lawmaker from the opposition Labour party.
LLOYDS MUST SELL BRANCHES
Lloyds was ordered to sell the branches by Europeanregulators as a condition of receiving state aid during the 2008financial crisis when Britain pumped 20.5 billion pounds intothe bank leaving taxpayers holding a 39 percent stake.
Industry sources said Lloyds will almost certainty need torequest that EU regulators extend the November 2013 deadlinethey have set for a sale, which analysts expect to be granted.
A flotation of the branches is unlikely to be possible untilthe second half of 2014, sources have said.
Industry sources also said Lloyds has been hit with about 1billion pounds in costs associated with the failed deal. Thebank made underlying pretax profit of 2.6 billion pounds in 2012and the Verde business, which comprises the branches for sale,has been making around 200 million pounds a year in profit,according to analysts.
Lloyds had prepared to operate the branches as a separatebusiness from August, using the TSB brand which disappeared fromthe high street in 1995 when TSB and Lloyds merged.
Verde has around 5 million customers and represents about 6percent of all bank branches in Britain.
Britain's "Big Five" lenders - Lloyds, HSBC,Barclays, Royal Bank of Scotland and SantanderUK hold 83 percent of current accounts. Co-op's 150year old banking business has only 2 percent.
A source close to the Co-op said there was no truth inspeculation that it would now pull out of banking. Its otherbusinesses include supermarkets, funeral services, travel andpharmacy.
Co-op's general insurance business was put up for sale lastmonth in a move to bolster its capital but it has so far failedto find a buyer.
Co-op's future strategy will be shaped by incoming chiefexecutive Euan Sutherland who takes the helm on May 1.Sutherland joins Co-op from European home improvement retailerKingfisher.
"The challenge they've got is how can they grow the bankingoperation because it is fairly clear to me that it is a bitshort on capital," said Shore Capital analyst Gary Greenwood.
With banks facing increasingly burdensome regulation andwith low interest rates constraining profitability, Sutherland,who has spent his career in retail, might want to focus on thatside of the business rather than banking, said analysts.
Co-op Bank made a loss of 674 million pounds last year. Theother businesses in the group also struggled as the UK recessioncontinue to bite.
Lloyds shares closed up 1.7 percent at 51.9 pence a shareafter a rise of 71 percent in the last 12 months.
