UPDATE 2-British funding scheme fails to boost business lending

* Net lending to all business down 3.9 bln stg

* Net lending to small businesses down 0.4 bln stg

* Biggest overall declines at state-backed Lloyds and RBS

* Lloyds was highest net lender to small businesses

* Funding Circle founder says scheme is failing businesses (Adds Funding Circle comments, bank-by-bank data)

By Matt Scuffham

LONDON, Aug 28 (Reuters) - Britain's much-heralded scheme toencourage banks to make more credit available to households andbusinesses failed to boost lending in the second quarter, datashowed, as banks focused on meeting tougher capital demands fromregulators.

The Bank of England launched its Funding for Lending Scheme(FLS) in August 2012 as a key part of government efforts tostimulate the economy, with banks having since drawn down atotal of 45.7 billion pounds ($75.8 billion) of funding.

The scheme was tweaked last November to end incentives formortgage lending with the intention of persuading banks to focuson businesses, but data from the Bank of England on Thursdayshowed that net lending to businesses fell by 3.9 billion poundsin the second quarter of this year, widening from a 2.7 billionpounds drop in the first quarter..

Lending to small businesses fell by 400 million pounds,though that was an improvement on a decline of 719 million inthe first quarter.

Britain's biggest banks have cut back on lending and shedassets to meet tough rules on capital that were imposed byregulators to prevent a repeat of the 2008 financial crisis.Banks have also pointed to a lack of demand from borrowers.

"Funding for Lending is failing to help the thousands ofBritish businesses that need finance but can't access it," saidJames Meekings, co-founder of Funding Circle, one of Britain'sbiggest online lending platforms.

ALTERNATIVE SOURCES

"Instead, alternative sources of finance, like peer-to-peerlending, are proving to be a better way for the Government toget finance through to British businesses," Meekings added.

Fewer smaller businesses in Britain are using traditionalforms of bank financing, such as overdrafts, loans and creditcards, a survey showed on Thursday.

The data showed that the biggest declines in lending came atstate-backed Lloyds Banking Group and Royal Bank ofScotland, where net lending contracted by 2.1 billionpounds and 1.5 billion pounds respectively.

The decline at Lloyds was driven by a 2.45 billion pounddrop in lending to large companies. Lending to small businessesrose by 384 million pounds, making it the scheme's biggestprovider of credit to small businesses.

RBS, which is majority owned by the British government, cutlending to big business by 1.13 billion pounds and to smallbusinesses by 360 million pounds.

The biggest rise in net lending came at Santander UK, which lent 254 million pounds to businesses, includingan increase of 99 million pounds for small businesses. Thenext-highest lender was new bank Aldermore, with net lendingtotalling 118 million pounds.

South Africa's Investec Bank increased net lending by 96million pounds with a 136 million pound increase in smallbusiness lending offsetting a 40 million pound fall in lendingto large companies.

The update covers the first full quarter since the changesto the scheme took effect in February.($1 = 0.6026 British Pounds) (Editing by Keith Weir and David Goodman)