UPDATE 3-British lender RBS to bolster capital after failing stress test

* State-backed RBS needs about 2 bln stg in additionalcapital

* Bank of England sees challenging outlook for financialsystem

* RBS shares fall as much as 4.6 percent

* Lender says will meet shortfall through cost cuts, assetsales

* Graphic: RBS's legal headaches http://tmsnrt.rs/2eV4Ihz (Adds further detail, BoE Governor quotes, shareholderreaction)

By Huw Jones and David Milliken

LONDON, Nov 30 (Reuters) - Royal Bank of Scotland(RBS) will cut costs and sell assets to boost capital, itsaid on Wednesday after failing its Bank of England stress test,with the central bank warning of a "challenging" outlook forBritain's financial system.

State-backed RBS rushed out a statement after the testresults to say it would take a range of actions to make up thecapital shortfall identified, amounting to about 2 billionpounds ($2.49 billion).

Shares in RBS, which was bailed out by UK taxpayers eightyears ago, fell 4.6 percent to 188 pence before reducing lossesto 2.9 percent at 1139 GMT.

The unexpected result underlines the litany of problems withwhich RBS is grappling, including a mounting legal bill formisconduct before the 2008 financial crisis and difficultiesselling off assets such as its Williams & Glyn banking business.

The Bank of England (BoE) approved RBS's new capital plan onTuesday night.

"Its challenge is that it still has legacy issues ...There's misconduct costs, there's impaired assets, they're stillworking through the so-called non-core assets, on which theyhave made progress," BoE Governor Mark Carney told reporters onWednesday.

"They are not talking about raising capital. The magnitudeof their plan is much bigger than the size of the shortfall inthe stress test."

RBS, which is expected to settle soon with U.S. authoritiesover alleged mis-selling of mortgage backed securities in therun-up to the financial crisis, said the measures approved bythe BoE should mean that it does not have to tap markets tocover the capital shortfall.

The bank is unlikely to have to sell any major assets andwill instead raise the additional capital by reducing exposuresin sectors including commercial property, oil and gas, a sourceat RBS said.

JOB CUTS, BRANCH CLOSURES?

Asset sales would avoid the embarrassment of a rights issue,that would force the government to put in even more taxpayermoney, given that it owns the majority of the shares.

RBS is expected to unveil a new cost-cutting plan at itsfull-year results in early 2017, which the source at the banksaid is likely to include job cuts and branch closures, andanalysts said the stress-test result would further delay RBS'sability to pay dividends.

"It is going to be very difficult. They have been doing thisfor a while," said Julian Chillingworth, Chief InvestmentOfficer at Rathbone Brothers, an RBS shareholder.

Chillingworth remains confident in RBS Chief Executive RossMcEwan, describing him as "on the case". Chillingworth said thatthe biggest worry would be if McEwan were to quit "because thisis as much a political job as it is a banking job".

Barclays also fell short by some measures in itsstress test but will not have to submit a new capital-raisingplan because it has already announced steps to strengthen itsdefences, including the planned sale of its African business,the BoE Financial Policy Committee (FPC) said.

Standard Chartered missed the test's minimum Tier 1capital target but also escapes the need for new capital-raisingbecause of steps already taken to cut costs and sell assets.

The performance of the seven lenders tested was worse thanmany market participants had expected.

"This is the highest average fall in CET1 (a measure ofcapital) and leverage ratios we've seen in the history of a UKconcurrent stress test," said Steven Hall, banking partner atKPMG.

TOUGHEST TEST

This year's health check, the third by the Bank of Englandsince the 2007-09 financial crisis forced taxpayers to bail outlenders such as RBS, was the toughest yet. Test scenarioscombined shocks to both global and domestic economies, as wellas the impact of potential misconduct fines.

Britain's banking system underwent a severe real-life testin June, when markets and sterling plummeted in response toBritain's vote to leave the European Union, and the Bank ofEngland said on Wednesday that Britain's financial system faceselevated Brexit risks and market volatility after the U.S.election.

HSBC, Lloyds Banking Group, Nationwide andSantander UK did not reveal any capital inadequacies inthe test, the central bank said, adding that the level ofcapital in the UK banking system was satisfactory overall at13.5 percent of risk-weighted assets.

The Bank of England also gave more detail on a second stresstest that will be introduced next year alongside its annualcheck, saying that it will cover a seven-year period -- comparedwith five in the basic test -- and look at "severe headwinds"challenging profitability.

Banks could be required to change business models to makethem more sustainable in the face of prolonged low interestrates and uncertainty over Britain's future relations with theEU after it leaves the bloc.

The Bank of England is now developing a system-wide test toassess the dynamics of broader markets under stress and willconduct an in-depth assessment of risks from derivatives trades.

The FPC also published on Wednesday an assessment ofinsurers' investment activities, concluding that changes areneeded to the EU's Solvency II insurance rules.($1 = 0.8018 pounds)

(Additional reporting by Lawrence White, Andrew MacAskill andSimon Jessop; Editing by Rachel Armstrong and David Goodman)