UPDATE 3-RBS chief says bad bank review a distraction
* RBS takes responsibility for resolving breakup debate-CEO
* Bank must address legitimate stakeholder concerns-CEO
* Treasury recommendations expected in coming weeks
By Matt Scuffham
LONDON, Oct 18 (Reuters) - Royal Bank of Scotland's (RBS) new Chief Executive Ross McEwan said a government review into whether the bank should be broken up is distracting executives looking to revive the fortunes of the state-backed lender.
Britain's finance ministry has asked investment bank Rothschild to examine if RBS, 81 percent owned by taxpayers, should be made to hive off its problem loans into a separate legal entity and a decision is expected in coming weeks.
McEwan, who became chief executive this month, does not want the issue to undermine his efforts to focus the bank more on customer service, an area which senior executives concede was neglected after its 45.5 billion pound ($73.7 billion) 2008 government rescue.
Advocates of a break-up, including former Bank of England Governor Mervyn King and ex-UK finance minister Nigel Lawson, have said it would leave the bank better placed to lend and support the UK economy.
"The debate you read about in the papers - and that has taken up too much time of the management team - has been about what is now a small proportion of our activity. We are taking responsibility for resolving these debates," McEwan said in a memo to staff on Friday seen by Reuters.
Even if a formal break-up is not recommended, RBS is considering creating its own internal "bad bank" to house more of its problem loans, industry sources have said.
In the memo, McEwan said a bad bank would only affect a small proportion of RBS's overall business. Ninety percent of the bank's assets are likely to be unaffected by the review, according to analysts.
RBS's capital position is coming under closer scrutiny, and a consultation being finalised by Britain's financial regulator has raised concerns UK banks may need to hold more than they had thought.
Morgan Stanley analysts estimated core capital at the end of this year, under full Basel rules, would be 9.3 percent at RBS, the same as at Barclays but compared with more than 10 percent for HSBC, Lloyds and Standard Chartered.
The regulator said in June RBS had a capital shortfall of 13.6 billion pounds ($22 billion), the biggest of any UK bank. McEwan sees the Treasury review as part of a process of reshaping the bank to remove all concerns around its capital strength within the next two to three years.
In the memo, McEwan said the bank's future will not be determined by whether it operates in particular areas or where its bad loans are held, but by how it treats its customers.
"The future of this company is about how good a job we do for our customers, including those who are having difficulty repaying their loans," McEwan said.
The 56-year-old New Zealander, who ran RBS's retail business for a year before he succeeded Stephen Hester, has pledged to return customers to the top of the agenda after his predecessor spent four years repairing its battered balance sheet.
Unlike Hester, McEwan has spent the majority of his career in retail banking and was previously head of retail banking at Commonwealth Bank of Australia, where he was credited with lifting retail banking profits by 50 percent in five years.