By Matt Scuffham and Steve Slater
LONDON (Reuters) - Britain's financial regulator warned the Co-operative Bank two years ago that it needed to raise capital and was not in a position to buy hundreds of branches from Lloyds Banking Group.
Andrew Bailey, the Bank of England's deputy governor for financial stability, told lawmakers the regulator had major reservations about Co-op's ability to acquire 632 branches put up for sale by Lloyds as a condition of its 2008 state bailout.
Bailey said he had raised five issues of concern with the Co-op: capital, liquidity, risk management, integration, governance and management.
"It was a pretty full-set, roughly everything," he said.
The Lloyds deal, codenamed Verde, collapsed in April after Co-op was found to have a capital shortfall, which the regulator has since identified to be 1.5 billion pounds ($2.3 billion).
Co-op is forcing bondholders to help plug that shortfall, using a 'bail-in' rescue model which will see them swap their debt for new bonds and equity in the bank, losing 500 million pounds in the process.
"We never approved the Co-op bid for the Verde branches. Going back to the outset of the process, about two years ago when it was first an idea, I said to the board of the Co-op Bank that they needed to raise capital," Bailey told parliament's Treasury Select Committee on Tuesday.
The decision by Lloyds to sell the branches to Co-op prompted allegations that politicians - keen to back customer-owned financial services businesses, such as Co-op, as an alternative to mainstream banks - had encouraged the choice.
However, Lloyds executives told the committee last month that they had not been subject to political pressure and made the decision to back Co-op's bid for commercial reasons.
Bailey said Lloyds had been skeptical about a rival bid for the Verde branches from new banking venture NBNK and had agreed to work on a listing were the Co-op deal to fall through.
($1 = 0.6568 British pounds)
(Editing by Louise Ireland)