UPDATE 2-Bank of England restricts stress tests to largest UK retail banks

(Adds banking reaction)

By David Milliken and Huw Jones

LONDON, Oct 21 (Reuters) - Britain's smallest lenders andunits of foreign investment banks operating in the country willescape the Bank of England's stress tests, the central bank saidon Wednesday, as the country seeks to boost competition inbanking.

The BoE said it will focus on major banks which account for80 percent of the country's lending, but left the door open tobroaden the scope of its annual tests to include other financialfirms such as asset managers.

"The United Kingdom needs banks that can weather shockswithout cutting lending to the real economy," BoE Governor MarkCarney said.

British taxpayers had to plough billions of pounds to propup RBS and Lloyds Banking Group after the 2008financial crisis, and lending to firms and households took yearsto recover, slowing economic growth.

Stress tests are designed to check banks have enoughreserves to cope with any future financial shock withoutimpacting day-to-day business or having to call on taxpayers forhelp.

BoE Governor Mark Carney said the focus on the largest bankswas intended to ensure the BoE's resources were focused onlenders which had the biggest effect on the economy. It willalso come as a relief to new entrants.

"The Bank's decision to link stress testing expressly to theneeds of the real economy will reassure business," the BritishChambers of Commerce said.

Simon Hills, an executive director at the British Bankers'Association, welcomed the BoE's clarification of its futureapproach, but said banks should still be allowed to rely ontheir own risk modelling.

The BoE did its first sector-wide stress test last year,which looked at how a housing market crash would damage banks'reserves, prompting Royal Bank of Scotland to raiseextra capital. The results of this year's test, which will focuson emerging market risks, is due on Dec. 1.

The BoE hopes that its approach will encourage banks to lendmore prudently, so that they find it easier to pass the stresstest.

From next year each bank will be given an individual passmark for the amount of capital it needs to hold at the end ofthe test, as opposed to the common hurdle in the tests so far.

This year all banks will have to show they still have a corecapital buffer of 4.5 percent at the end of the test, but thishurdle is set to be around six percent next year.

Introducing different pass marks will make comparisonsbetween lenders difficult, and the continued lag in publishingtest results was disappointing, said Steven Hall, a bankingpartner at KPMG consultancy.

The BoE said it did not think there would be much benefit toconducting extensive probes of the British units of foreigninvestment banks, as their financial health depended on theirparent companies, which the BoE cannot regulate.

Only banks with more than 50 billion pounds ($77 billion) ofretail deposits will be covered by the stress tests, whichincludes RBS, Lloyds, HSBC, Santander UK,Standard Chartered and Nationwide Building Society.

Every two years, the BoE will hold a separate stress test tolook at structural risks, which could include banks' exposure tocurrency pegs or industry-wide changes.

Stress tests for the 50 percent of Britain's financialsector which is not made up of banks are also on the agenda,though there is no precise timetable.

The BoE said the model it applied to banks would often notbe appropriate. Many of the risks in non-banks are sector-wide,for example, if a number of mutual funds tried to exit a singleasset category at once.

($1 = 0.6475 pounds)

(Reporting by Huw Jones and David Milliken; Editing by ElaineHardcastle)