By Andrew MacAskill and Francesco Guarascio
LONDON/BRUSSELS (Reuters) - Britain's plan to free Royal Bank of Scotland <RBS.L> from an obligation to sell more than 300 branches risks a clash with the European Commission weeks before the government is due to start formal talks to leave the trading bloc.
European regulators originally told RBS to sell the branches by 2013 to prevent the state-backed bank, Britain's largest small-business lender, from having an unfair advantage. The sale was one of the conditions attached to RBS's 45.5 billion pound ($55.87 billion) state bailout in the financial crisis.
RBS has spent more than 1.5 billion pounds and seven years trying to spin-off the branches - which were to be branded Williams & Glyn - but has struggled to separate them from its IT system.
Now British finance minister Philip Hammond is pushing for RBS to be let off the EU's demand to sell the branches in return for providing around 750 million pounds ($931.73 million) to help to boost competition in banking.
For the plan to work, the EU would have to approve changes to the terms of RBS's government bailout, which included the sale of the branches and other divestments.
The British government and the European Commission say they have had "constructive" discussions over the matter.
RBS shares surged to a one-year high on Monday as investors bet the proposals would be accepted. An end to the bank's state aid commitments is seen as a big milestone on the path towards the bank's recovery and the restoration of dividends.
But the plan still needs to be vetted by the European Commissioners, who may reject the British government's proposals and seek to impose tougher conditions on RBS to free it from the branch sale obligation, according to sources familiar with the matter.
The Commission will have to assess whether the measures that RBS will take are equivalent to selling the branches, a process likely to take at least several weeks.
On paper, analysts said the proposals looked to be very much in the bank's favour, given it was expected to have had to sell Williams & Glyn with a hefty writedown.
The 750 million pounds RBS is proposing to spend on alternative measures to help so-called challenger banks and boost competition is substantially less than the charge that many had expected it would have to book for a distressed sale, Sandy Chen, an analyst at Cenkos Securities, said.
EU officials said on Monday that they were still waiting for formal notice of RBS's plan, but that it would go through thorough vetting.
"In order to gather information on this proposal, the Commissioner responsible for EU competition policy, Margrethe Vestager, will in the coming weeks propose to the college of commissioners to open proceedings," a spokesman said on Monday.
The Treasury said in a statement the plan provided a blueprint to increase competition and any final decision about what RBS must do would be made following the Commission's investigation and reaction to the plan from smaller banks.
RBS declined to comment.
The British government will argue that the new plan would deal with the state-owned bank's EU obligations more quickly and with more certainty than selling off the branches.
The government will also say that the current plans would boost competition to a larger number of smaller banks, according to government officials.
The Treasury began working on an alternative plan in the autumn soon after RBS abandoned an idea to build an independent technology platform for Williams & Glyn, according to people with knowledge of the talks.
It hired investment firm Rothschild and law firm Slaughter and May to help find alternative ways to meet the state aid requirements, according to sources.
Rothschild and Slaughter and May declined to comment.
If a deal is reached it would remove one of the two remaining uncertainties hanging over RBS - the sale of the branches and an expected multi-billion dollar fine in the United States for claims that RBS mis-sold mortgage bonds in the run-up to the global financial crisis.
Peter Hahn, a professor of banking at the London Institute of Banking & Finance, said RBS had endured almost a decade of losses since it was bailed out in 2008 and the EU should show RBS some mercy.
"The days of arrogant RBS are in the past," he said. "Now when you mention their name there is nothing but sympathy."
($1 = 0.8055 pounds)
(Additonal reporting by Foo Yun Chee; editing by Jane Merriman and Jason Neely)