LONDON (Reuters) - Lloyds Banking Group (LLOY.L) was told in December 2011 that it was not clear the Co-operative Bank CPBB_p.L had a "feasible and sustainable capital plan" to buy more than 600 branches from Lloyds, regulatory and banking sources said.
The three sources, who have direct knowledge of the matter, said an email sent in December 2011 by Britain's financial regulator did not explicitly warn of a capital hole at Co-op, but said it was not clear that the mutual could transform itself into an organization capable of completing the purchase.
Lloyds chief executive Antonio Horta-Osorio and chairman Win Bischoff told a British parliamentary committee in June that they first became aware that the Co-op Bank was facing a capital shortfall in December 2012. The Prudential Regulation Authority said in June this year that the shortfall amounted to 1.5 billion pounds ($2.3 billion).
Lloyds, the Co-op and the PRA declined to comment.
Lloyds was ordered to sell the 632 branches by European regulators as part of its 20.5 billion pound ($31 billion)taxpayer rescue in 2008, but its choice to sell to the Co-op has been slammed after a big hole appeared in the mutual's finances.
The Treasury Select Committee quizzed Lloyds executives on their decision, since abandoned, to sell the branches to the Co-op, rather than to a rival start-up bidder NBNK.L, which said it made a higher offer.
Lloyds may be called back to the committee to explain why it persisted with Co-op as its preferred bidder.
Sources with knowledge of the matter said Andrew Bailey, then director of UK banks and building societies at the regulator, raised concerns over the deal, codenamed Project Verde, in an email dated December 20, 2011, which was sent to Co-op executives and forwarded to Bischoff.
Bailey outlined key areas that would need to be addressed before regulatory approval could be granted, including Co-op's management, computer systems, funding and capital. He said Co-op had yet to produce a feasible capital plan.
"Our current view is that it is not clear Co-op has the ability to do that," Bailey said in the email, sent to Co-op's then-chairman Len Wardle and chief executive Peter Marks.
Bailey acknowledged Co-op had already communicated elements of the regulator's concerns to Lloyds ahead of Lloyds selecting it as preferred bidder earlier that month but added: "To avoid any possibility of ambiguity I would be grateful if you could also provide them with a copy of this letter".
Sources with direct knowledge of the matter said that Bischoff was subsequently forwarded a copy. Lloyds picked Co-op as the winner of the auction last July.
Bailey, Horta-Osorio, Bischoff, Wardle and Marks could not be reached for comment.
Bailey told the Treasury Select Committee of British lawmakers that he had been "very insistent" that Lloyds were told and that he had wanted to avoid a situation where the deal fell through and Lloyds turned around and said: 'If only you had told us'".
Co-op was chosen to buy the branches ahead of NBNK, whose chairman Peter Levene says he handed a document to Bischoff early last year, spelling out the risks of selling the branches to the Co-op. Lloyds said it had "no record or recollection" of receiving that document.
Co-op said on Friday it had launched an independent review into the problems at its bank, to be led by Christopher Kelly, a former senior government official.
Lloyds is pressing ahead with a stock market listing of the branches, reviving the TSB brand, which was last seen on the British high street in the 1990s.
(This story is corrected in first paragraph show it was not clear Co-op had a feasible plan, instead of "did not have", as originally sent)
Editing by Louise Heavens