Lloyds has to sell the branches on condition of receiving state aid when it was bailed out by the U.K. government in 2008. The sale process has been dogged by regulatory problems and muted interest among potential investors.

On Thursday, the bank said the sale was continuing as planned and that The Co-operative Group, a member-owned groceries-to-banking business, remained the preferred bidder. However, Lloyds warned in a statement that the transaction was "highly complex" and that a further update would be given to the market in the second quarter of the year. Lloyds had originally said it would give more details on the sale at the end of the first quarter of 2012.

"It's an enormous warning shot to the government," Mike Trippitt at Oriel Securities said. "It looks like the Co-op are not up for it."

The sale of the branches was heralded by the British government as a way to boost competition in the U.K. banking sector. However, the creation of the much-trumpeted "challenger bank" has yet to materialize. The combination of stringent regulation, bleak macro-economic outlook and the presence of five established banks has dulled interest in the U.K retail banking market, analysts say.

In December, the Co-op was chosen as preferred bidder for the branches over rival NBNK Investments PLC (NBNK.LN). Both offers valued the business at around GBP1.5 billion. However, the bid by the Co-op has been hampered by regulatory issues. In part, the U.K.'s regulator, the Financial Services Authority, raised issue over the experience of the Co-op's board, which count a nurse and a medicinal-plant consultant among its members.

One option on the table would involve making the whole group--which comprises a retail and legal and insurance services as well as a bank network--an FSA-regulated entity. This would likely involve higher capital requirements, across the group. Another possibility would be to ring-fence the bank, which has its own 14-strong board, from the rest of the group. The Co-op is currently looking for a new chief executive for its banking group.

Thursday, Lloyds confirmed that a flotation of the 630 branches remains an option and that a decision on this would be made in the second quarter.

The bank said that around 1,400 existing employees in five U.K. locations providing telephony, banking operations and mortgage-center support will form part of the 632 branches and 1,400 staff that are already included in the business being sold, also known as Verde. In addition, the bank is recruiting 500 new employees for the overall Verde business.

"It feels increasingly as though Verde is being set up to be a standalone business, as opposed to being part of another bank," wrote Gary Greenwood at Shore Capital. Lloyds, which is 40%-owned by the British government, was ordered to by the European Commission to sell the branches by the end of 2013.

At 1600 GMT, Lloyds shares were down 2% at 35 pence in a down day for U.K. banks.

-By Marietta Cauchi and Max Colchester, Dow Jones Newswires; +44 207 842 9241; marietta.cauchi@dowjones.com

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