* FSA watchdog says move to ease impact on lending
* Says banks will need to grow govt bond hldings by $175 bln
* Says no toughening of standards before recovery assured
* Bank association says business models will be hit
(Adds reaction, more detail)
By Huw Jones
LONDON, Oct 5 (Reuters) - Britain's banking sector will have several years to comply with tougher liquidity rules aimed at ensuring it can navigate sudden market storms unaided, but lenders say the reform process will still hurt business.
"Phasing the period in which firms will build up their liquidity buffers should mitigate the knock-on effects to bank lending," Paul Sharma, the Financial Services Authority's director of prudential policy, said in a statement on Monday.
"The FSA will not tighten quantitative standards before economic recovery is assured."
The new rules take effect on Dec. 1 but banks won't have to start reporting liquidity holdings, daily for some, until June 2010, about three months later than originally flagged. British branches of overseas banks have until Nov. 1 2010. Failure to comply will have undefined "regulatory consequences".
The rules, which follow on from a government blueprint presented in July, are expected to boost demand for British gilts at a time when the government is borrowing heavily to service higher debt incurred partly from bailing out banks.
The timing of their introduction, months ahead of similar schemes in other countries, also seems likely to damage UK banks' competitiveness, observers believe.
"This is a temporary fix and the FSA is first to the market on liquidity rules. If the FSA is not followed in Europe it could be an immensely expensive temporary fix that makes Britain temporarily less competitive," said Simon Morris, a financial lawyer at CMS Cameron McKenna
'A WORLD FIRST'
The FSA estimated full introduction of the new regime -- which it says is a world first by a major regulator -- would require banks to collectively increase holdings of highly-liquid government bonds by 110 billion pounds ($175.6 billion), or an annual cost of 2.2 billion pounds.
Liquidity requirements for big firms will be calculated on a case-by-case basis but banks warn they cannot keep lending to aid recovery from the worst financial crisis since the Great Depression and conform to an abundance of higher capital and liquidity rules.
Banks also worry about the consequences of being bound to the new rules sooner than their rivals in other countries, which are not expected to follow suit until late 2010 onwards.
The British Bankers' Association said the FSA's reforms will oblige banks to hold high amounts of government bonds rather than allowing them to diversify their assets, while the watchdog wants banks to hold assets that can be turned into cash quickly.
"Inevitably the transition to this regime will impact banks' business models," the BBA said in a statement.
Consultancy PriceWaterhouseCoopers said banks faced a major increase in costs which could impact profitability and will result in a strategic shift in how a bank operates.
The FSA first unveiled plans to tighten liquidity rules in Dec. 2008 and on Monday published the final version with some tweaks to phasing in timetables along with a reduction in the number and frequency of items that must be reported.
Auditing firm BDO said smaller brokers will welcome news the FSA is asking for less frequent reporting than planned.
STRATEGIC SHIFT
The UK watchdog is seeking to apply lessons from the credit crunch, which saw some banks holding too little cash or cash like assets to tide them over when wholesale money markets suddenly dried up.
The British government was forced to nationalise banks like Bradford & Bingley and Northern Rock.
The new rules would also make sure that foreign branches of banks in the UK hold enough liquidity -- a lesson learnt from troubles with Icelandic banks that had customers in the UK.
The FSA said it plans to phase in the quantitative aspects of the regime in several stages, over several years.
"All firms at present are experiencing a market-wide stress. The precise amount of liquidity that each firm will need to hold will be refined over time to ensure (proportionality)," the FSA said.
It said the phasing in of the new rules would be flexible enough to reflect new international standards once they had been agreed.
The Basel Committee on Banking Supervision is set to agree on a global liquidity framework in December which would include the use of simple ratios, but implementation is unclear.
The European Union's Committee on European Banking Supervisors (CEBS) is finalising non-binding guidelines. The European Commission is also set to unveil proposals to reform bank capital rules this month and may touch on liquidity.
At 1452 GMT, shares in major UK banks were trading mixed, ranging from a rise of 0.2 percent by Lloyds to a fall of 0.3 percent at HSBC. The European banking sector was up 0.5 percent, lagging the broader market. (Reporting by Huw Jones, editing by John Stonestreet)