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* UK banks have access to cheap funding from BoE
* Ring-fencing will reduce need for state bailouts
* RBS, Lloyds borrowing costs broadly stable
By Matt Scuffham
LONDON, Feb 25 (Reuters) - The borrowing costs ofpart-nationalised British banks were unaffected on Monday byBritain's loss of a triple-A rating due to measures that had cuttheir dependence on the bond market and may reduce their needfor bailouts in future.
On Friday Moody's Investors Service stripped Britain of itscoveted triple-A rating by one notch. The state owns 82 percentof Royal Bank of Scotland and 41 percent of Lloyds after stepping in to rescue them during the financialcrisis.
Since then, the banks have shifted their focus to moretraditional lending and away from the high-flying, more riskytrading that got them into trouble.
"The reality is that the total level of senior bond issuancefrom all the UK banks has been declining as they shrink thenon-core and increase deposits within the mix, so the directimpact is pretty limited," one of RBS's 10 largest shareholders,who declined to be named, said.
RBS has shed around 700 billion pounds ($1.1 trillion) inassets in the wake of the financial crisis, while Lloyds hastargeted the sale of 200 billion pounds worth of unwanted loansand investments.
Helping that shift, the Bank of England's Funding forLending Scheme allows lenders to access cheap funding for makingloans to small businesses and households and has reduced theirneed to tap wholesale funding markets.
Investors also cited prospects for new laws that wouldring-fence deposits held by individuals and small businessesfrom riskier activity, so that they are unaffected if the riskyside of a bank fails, putting less pressure on the government tojump to the rescue.
"In theory, this should reduce the correlation between banksand the sovereign," said Andrew Coombs, an analyst at Citi.
EVEN MORE VULNERABLE TO ECONOMY
The fortunes of RBS and Lloyds are becoming more closelylinked to the British economy, however, as they retrench fromoverseas markets.
"The risk remains that economic conditions could deterioratemore severely, leading to reduced levels of activity and higherimpairment losses," Coombs said.
Lloyds Chief Executive Antonio Horta-Osorio has warned of a"long and difficult recovery" for the British economy.
James Carrick, an economist at Legal & General InvestmentManagement, said Britain's banks were already rated threenotches below the sovereign, so he is not expecting an automaticfollow-up change in their ratings.
"This downgrade is bad news for the government, because theyare going to have to reconsider the fiscal tightening they aregoing to have to do, but I wouldn't have expected a massiveshock to the funding costs of banks at this stage," he said.
Moody's has an negative outlook on both banks, meaning thatfuture downgrades are possible.
At the close of trading on Monday, shares in Royal Bank ofScotland were up 2.8 percent, boosted by news the bankplans to sell off part of its U.S. business, while LloydsBanking Group was up 0.1 percent.
Markit, a firm that provides data on financial marketsincluding credit derivatives, said the downgrade had alreadybeen factored in and the constraints on Britain's growthprospects were already well known.
"This captured lots of headlines, but had a negligibleimpact on stock and credit markets. The downgrade was more orless priced in," it said.
On the bond markets, the European subordinated financialindex was 9 basis points tighter at 246 basis points and thesenior financials index was 4 basis points tighter at 146.5basis points.
"We don't expect any ratings impact from the UK downgrade,"a bank analyst said. "In countries like France where thesovereign has been downgraded, we've seen covered bonds issuedby the country's banks maintain their triple-A rating, whichshows that in some cases investors are more comfortable withbank debt than government bonds."
Moody's changed its outlook on the UK to stable after thedowngrade, meaning any further change is unlikely for the nextyear or so. Standard & Poor's and Fitch still have the countryon a top-notch rating but their outlook is negative.
