UPDATE 2-UK to scale back bank levy, softens tone of sector regulation

* Shares in HSBC edge higher on news of changes

* Banks say overall tax bill will rise, hit new entrants

* Bank of England asked to pay heed to competitiveness (Adds more detail, banking, City of London reaction)

By Huw Jones

LONDON, July 8 (Reuters) - Britain will largely replace alevy on bank balance sheets with a surcharge on profits in amove experts said would help quell talk among lenders of movingelsewhere to lighten their regulatory burden.

UK Finance Minister George Osborne offered further comfortto banks facing a welter of new rules since the financial crisisby asking their regulator, the Bank of England, to help keepBritain a "highly attractive" location for lenders.

The bank levy was introduced in 2011 in response to thefinancial crisis and applies to the global balance sheet assetsof British banks as well as assets belonging to the UKoperations of foreign banks.

It has raised over 8 billion pounds and is now expected toraise nearly 4 billion pounds annually.

Banks said the tax is unfair as it becomes more punitivewhen profitability falls. Europe's biggest bank, HSBC,has said the levy will be a factor in whether it decides to keepits headquarters in Britain.

"I will, over the next six years, gradually reduce the banklevy rate, and after that make sure it no longer applies toworldwide balance sheets," Osborne told parliament as hedelivered his post-election budget.

Applying the levy only to banking assets in Britain willbenefit HSBC, whose shares rose, and Standard Chartered in particular as they have a high proportion of theirassets overseas.

It also reduces the competitive disadvantage for UK banksagainst foreign rivals operating in Britain.

"But to maintain a fair contribution from the banks, I willintroduce a new eight percent surcharge on bank profits from thefirst of January next year," Osborne said. The surcharge wouldbe partly mitigated by a cut in corporation tax to 18 percent.

"By getting this balance right, it means we'll actuallyraise more from the banks this parliament, but at the same timemake our country a more competitive place to do business."

Bank shares initially rose after Osborne's announcement butlater fell back as markets digested the news. Earlier this week,bankers urged Osborne to cap the levy rate and consider phasingit out.

The British Bankers' Association welcomed moves to reduce"damage" from the levy but said that a surcharge would mean thesector paying more tax overall and bring smaller banks under thenet while dampening competition from new entrants.

Shares in smaller British banks such as Aldemore,Onesavings, Virgin Money and Shawbrook tumbled on the news, down around 10 percent.

"We await to see whether today's moves are sufficient toconvince those banks that the government has been listening tothe concerns of the sector," said Alan Yarrow, mayor of the Cityof London financial district.

"SUPPORT MY VISION"

Dan Neidle, a tax partner at Clifford Chance law firm, saida surcharge would help eliminate the tax disadvantage for banksto keep their head office in Britain, Neidle said.

"Overall, this reform should improve UK competitiveness. Itshould make it easier for banks to forecast and afford their taxcosts," added Wayne Weaver, a banking tax partner at Deloitte.

The government has raised the bank levy rate repeatedlysince its launch because many banks scaled back their operationsafter the crisis, meaning there were fewer assets to tax.

Osborne began sounding more conciliatory towards banks in aspeech in June when he said he wanted Britain to be the besthome for global banks and talked of a "new settlement" for theindustry.

This shift was fleshed out in the finance ministry's annual"remit" for the Bank of England's Financial Policy Committee ina letter on Wednesday to BoE Governor Mark Carney.

The FPC, tasked with spotting risks to Britain's financialsystem, has been among the world's most hawkish regulators,forcing banks to hold far more capital than globally agreednorms.

But Osborne said he wants the City of London to remain theworld's leading international financial market and for Britainto remain a highly attractive location for domicilinginternationally active financial institutions.

"Therefore... the FPC should give consideration to how itsactions can support the achievement of this vision," Osbornewrote to Carney.

(Additional reporting by David Milliken, William Schomberg andKate Holton; Editing by Mark Heinrich)