UPDATE 3-RBS chief says bad bank review a distraction

* RBS takes responsibility for resolving breakup debate-CEO

* Bank must address legitimate stakeholder concerns-CEO

* Treasury recommendations expected in coming weeks

By Matt Scuffham

LONDON, Oct 18 (Reuters) - Royal Bank of Scotland's (RBS) new Chief Executive Ross McEwan said a government reviewinto whether the bank should be broken up is distractingexecutives looking to revive the fortunes of the state-backedlender.

Britain's finance ministry has asked investment bankRothschild to examine if RBS, 81 percent owned bytaxpayers, should be made to hive off its problem loans into aseparate legal entity and a decision is expected in comingweeks.

McEwan, who became chief executive this month, does not wantthe issue to undermine his efforts to focus the bank more oncustomer service, an area which senior executives concede wasneglected after its 45.5 billion pound ($73.7 billion) 2008government rescue.

Advocates of a break-up, including former Bank of EnglandGovernor Mervyn King and ex-UK finance minister Nigel Lawson,have said it would leave the bank better placed to lend andsupport the UK economy.

"The debate you read about in the papers - and that hastaken up too much time of the management team - has been aboutwhat is now a small proportion of our activity. We are takingresponsibility for resolving these debates," McEwan said in amemo to staff on Friday seen by Reuters.

Even if a formal break-up is not recommended, RBS isconsidering creating its own internal "bad bank" to house moreof its problem loans, industry sources have said.

In the memo, McEwan said a bad bank would only affect asmall proportion of RBS's overall business. Ninety percent ofthe bank's assets are likely to be unaffected by the review,according to analysts.

UNDER SCRUTINY

RBS's capital position is coming under closer scrutiny, anda consultation being finalised by Britain's financial regulatorhas raised concerns UK banks may need to hold more than they hadthought.

Morgan Stanley analysts estimated core capital at the end ofthis year, under full Basel rules, would be 9.3 percent at RBS,the same as at Barclays but compared with more than 10percent for HSBC, Lloyds and StandardChartered.

The regulator said in June RBS had a capital shortfall of13.6 billion pounds ($22 billion), the biggest of any UK bank.McEwan sees the Treasury review as part of a process ofreshaping the bank to remove all concerns around its capitalstrength within the next two to three years.

In the memo, McEwan said the bank's future will not bedetermined by whether it operates in particular areas or whereits bad loans are held, but by how it treats its customers.

"The future of this company is about how good a job we dofor our customers, including those who are having difficultyrepaying their loans," McEwan said.

The 56-year-old New Zealander, who ran RBS's retail businessfor a year before he succeeded Stephen Hester, has pledged toreturn customers to the top of the agenda after his predecessorspent four years repairing its battered balance sheet.

Unlike Hester, McEwan has spent the majority of his careerin retail banking and was previously head of retail banking atCommonwealth Bank of Australia, where he was creditedwith lifting retail banking profits by 50 percent in five years.