* Withdrawal would mean cash call of up to 20 bln sterling
* Lloyds would face charge for cost of insurance so far
* UK government could block Lloyds exit
By Clara Ferreira-Marques
LONDON, Aug 12 (Reuters) - Tentative signs of a recovery may tempt Britain's Lloyds to consider cutting itself loose from a government scheme to insure bad debts, but a withdrawal would be complex, costly and potentially damaging for shareholders.
Industry sources say Lloyds Banking Group Plc is gauging appetite for a bumper rights issue of as much as 20 billion pounds ($32.9 billion) to allow it to reduce reliance on the government and avoid 15.6 billion pounds of fees to take part in the scheme.
Lloyds, which raised 4 billion pounds from shareholders earlier this year, has declined to comment and says it is pressing ahead with talks with the government on the terms of the scheme.
And it should stick to that plan for now, analysts say.
Although it needs to consider all its options and the cost of the Asset Protection Scheme (APS) looks high now that markets are showing signs of life again, that does not mean investors would be better off without it.
The gamble involved in pulling out of the insurance scheme -- leaving shareholders to shoulder the risk instead -- and the potential difficulties of pushing through a record-breaking rights issue would be simply too great for loss-making Lloyds.
"I think this is premature," said analyst Leigh Goodwin at Fox-Pitt, Kelton, who estimates Lloyds would have to raise its key core Tier 1 ratio from 6.3 percent to at least 10 percent, without the APS, a move that would cost up to 20 billion pounds.
"Even if they are right (about the outlook), they are not telling us the company is going to be profitable this year. The sheer amount they would have to raise rules out a rights issue to replace asset protection, and any alternative to "B" shares (issued to the government to pay for the scheme fee) would be less preferable for shareholders."
The government could also block its exit if it viewed such a move as risking the health of a financial system that is still tottering back onto safe ground.
Lloyds is the country's largest retail bank, 43 percent-owned by the UK government, and remains in a fragile state. Its first-half loss was the largest among European banks at almost 4 billion pounds.
It would also face a hefty bill from the Treasury -- up to 1.5 billion pounds, according to some estimates -- for the cost of the safety net the government has provided since March.
WORST OF BOTH WORLDS?
Lloyds agreed earlier this year to include 260 billion pounds of risky assets in the Asset Protection Scheme.
The scheme shielded Lloyds from potentially massive losses -- above an agreed 25 billion pound "first loss" -- and helped boost its capital ratios by reducing risk-weighted assets.
It came at a cost, however -- 15.6 billion pounds in fees to be paid to the government in "B" shares, which do not carry voting rights but which would dilute existing shareholders.
"The (scheme's) benefits are enormous, but Lloyds have already had the main one. They have had insurance over the past two quarters and avoided a run on Lloyds," said one analyst who declined to be named. "Obviously they'd like to avoid paying now."
Assuming a 6.5 billion pound benefit from the boost to capital ratios -- according to analysts at Credit Suisse -- the insurance would have to pay at least 9 billion pounds before the scheme started to pay up for Lloyds.
Potentially adding to reasons for the bank to reconsider its position, it said last week it would reduce its balance sheet by running down 200 billion pounds of risky assets, the bulk of which may have been earmarked for the APS. It said there was a "signficant overlap" between the two, but gave no detail.
Tough talk from EU antitrust regulators has also struck fear in some quarters that Lloyds could be forced to sell off assets -- and the bank may want to keep the government's stake below 50 percent to limit any European moves. Under APS, the UK's stake could rise to over 60 percent, though voting rights would be limited.
However, leaving could prove too big a gamble for Lloyds and its top shareholder, the government.
The bank said last week it had put two-thirds of its first-half bad debts in the scheme, meaning it has already gobbled 10 billion of its 25 billion pound first loss. That brings it closer to dipping its hand into public pockets again, unless impairment trends improve.
Most critically, pulling out of the scheme would force Lloyds to draw up plans for the world's largest share offering to date, likely at a deep discount and with the government again underwriting the issue -- hitting national accounts again.
Few believe that is a possibility, even in rosier markets, and several top shareholders have said they are less than keen.
Analysts say that, at most, Lloyds may try to negotiate a reduction in its involvement in APS, potentially a partial exit through a smaller rights issue. Even that, though, would prompt renegotiations and could delay the scheme for months -- an option, according to one industry source, that the government is loathe to contemplate.
"While we doubt that APS will be hugely profitable for shareholders, and while we expect continued speculation surrounding accession, we think it is likely that Lloyds and Royal Bank of Scotland will still enter the scheme at a relatively material level," Credit Suisse said in an note. ($1=.6059 Pound) (Reporting by Clara Ferreira-Marques; editing by Simon Jessop)