By Huw Jones and William Schomberg
LONDON (Reuters) - The Bank of England, seeking to protect the City of London's status as a global financial hub, said it would spare European banks costly capital rules after Brexit but warned of "consequences" if negotiations with Brussels turned sour.
Ahead of a tussle with Brussels, the BoE said on Wednesday keeping Britain open to foreign banks was key for economic growth at home and in the region.
BoE Governor Mark Carney said European banks operating in Britain would face little change after Brexit, as long as their supervisors in the European Union cooperated with London.
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"But we retain all our options and if that is not forthcoming there will be consequences for those institutions," he told lawmakers shortly after the BoE plan was published.
Deputy Governor Sam Woods said cooperation had worked well to date. "However Brexit is throwing up a point of tension which I think will probably build rather than subside."
The BoE's announcement was a first salvo in an expected struggle with the EU over banking rules that will decide the long-term fate of London's lucrative financial center.
Prime Minister Theresa May has said Brexit will mean leaving the EU's single market, raising questions about how British firms will do business in the bloc and European ones in Britain.
A bitter British divorce from the EU would make cross-border supervisory cooperation harder and potentially hurt banks with a big London presence.
It could also hurt public finances, as Britain collects over 70 billion pounds a year in tax from the financial services sector.
In a welcome development for firms such as Germany's Deutsche Bank, the BoE said it would allow larger banks - for example, with assets of more than 15 billion pounds ($20 billion) in Britain - to operate as branches in the UK.
But if their home supervisors did not cooperate more closely with the BoE, the firms would be classed as subsidiaries, which would require them to park costly extra capital in Britain.
There are 77 branches of banks from the European Economic Area in Britain - 23 of which have assets of around or above 15 billion pounds - plus 80 branches of insurers.
Management consultancy Boston Consulting Group has estimated that EU banks would have to find up to 40 billion euros if all their branches in Britain were turned into subsidiaries.
Deutsche Bank has 9,000 staff in London. France's BNP Paribas and Societe Generale have 6,500 and 4,000.
The BoE's proposal indicated a softer British position than that of the EU which on Wednesday stiffened its rules for non-EU investment banks which operate inside the bloc.
Many of those banks, such as Goldman Sachs and Morgan Stanley, have their main European operations in London, though they are making plans to move some operations to EU centers.
The EU has insisted that London-based banks will lose their free access to the EU if Britain sticks to its plan for new controls on migration, which is popular with British voters but would breach a condition for membership of the single market.
The BoE's Carney sounded upbeat about prospects of a deal, saying the financial services sectors on both sides of the English Channel had a lot in common already.
"I don't accept the argument that just because it hasn't been done in the past it can't be done in the future," he said.
LONDON'S STATUS IN QUESTION
London vies with New York as the world's financial capital. It dominates the $5.1-trillion-a-day global foreign exchange market and hosts more banks than any other center. But other EU capitals see Brexit as an opportunity to grab new business.
The EU has already proposed that clearing of euro-denominated derivatives, done mainly in London, could move to the euro zone without a comprehensive Brexit deal.
The BoE's conditions on whether branches should become subsidiaries will be seen as a riposte the euro clearing plans in Brussels, which also emphasizes the need for strong supervisory cooperation to avoid forced relocation.
The Association for Financial Markets in Europe (AFME), grouping European banks, said the BoE's announcement would allow banks to get on with their planning for Brexit.
The BoE plans to start reauthorizing the branches of up to 200 EEA financial firms in Britain in early 2018. It hopes Britain will secure a Brexit transition deal to start after Brexit in March 2019 to give regulators more time.
The new policy will not affect banks from outside the EU.
The central bank said retail-focused branches of EU insurers currently operating in Britain will need to become subsidiaries, in line with an existing rule for foreign retail banks.
The BoE will also get powers to "recognize" and supervise clearing houses from the EU after Brexit.
($1 = 0.7458 pounds)
(Additional reporting by David Milliken and Andy Bruce; Editing by Guy Faulconbridge and John Stonestreet)