* Says faces 400 million pound bill for past misconduct
* Expects 2013 loss of 1.2-1.3 billion pounds
* Co-op Group considering whether to contribute
* Capital raising expected to take place in Q2 -source
* Ex-BoE governor King defends Lloyds branch sale process (Adds details on likely timing, structure of sale)
By Matt Scuffham
LONDON, March 24 (Reuters) - Britain's Co-operative Bank needs to raise another 400 million pounds ($660 million) to cover the cost of past misconduct, dealing a fresh blow to the lender which promotes its ethical standards but has been hit by a funding gap and drugs scandal.
Co-op Bank was controlled by the Co-operative Group , Britain's biggest mutually-owned company, until last year, when regulators identified it had a 1.5 billion pound capital shortfall.
This led to a refinancing in which control of the bank passed to a group of hedge funds - including Perry Capital and Silver Point Capital - and the bank's problems were exacerbated when former chairman Paul Flowers was arrested as part of an investigation into the supply of illegal drugs.
Co-op Bank, which has about 4.7 million customers and is Britain's eighth-largest provider of current or checking accounts, said on Monday an internal review had shown it needed to set aside about 400 million pounds to meet costs related to previous misdeeds.
This would cover compensation for mis-sold loan insurance, breaches of consumer credit rules, repayments to mortgage customers who were overcharged and compensation to small companies mis-sold complex hedging products, it said.
"The result of providing for these items, together with the cost of separation from the Co-operative Group, is that the starting capital position of the bank for the four- to five-year recovery period is weaker than in the plan announced last year," Chief Executive Niall Booker said.
The bank, whose ethical stance is based on policies such as not lending to the likes of weapons makers, said it expected to post a loss before tax of between 1.2 and 1.3 billion pounds for 2013, excluding profit generated by its restructuring.
Many UK banks are facing hefty fines and compensation bills due to a variety of misdeeds, but analyst Gary Greenwood at brokerage Shore Capital said Co-op's latest charge was higher than expected. "The scale of the provision is obviously quite material. The surprise is more around the size of it," he said.
Banking group UBS has been hired by Co-op Bank to advise on the capital raising. Sources familiar with the matter said existing shareholders would be given first option to buy new shares, but new investors could be sought if they fail to take up all of the offer.
Co-op Group, which still owns around 30 percent of the bank, said it was considering whether to participate. "As a shareholder in the bank we will consider our position in relation to the proposed additional capital raising as and when appropriate," it said in an emailed statement.
Co-op would need to contribute 120 million pounds to maintain its stake at 30 percent.
Co-Op Group had in January scrapped the planned sale of its general insurance business, saying Co-op Bank's restructuring plan at that time would not require it to contribute as much capital as originally envisaged.
Co-op Bank said that, as a result of the charges, its core equity buffer was expected to be around 7.2 percent, only just above the 7 percent minimum requirement set by Britain's financial regulator and below previous guidance of towards 9 percent.
Preparations for the capital raising will be stepped up after Co-op Bank's annual report is published on or before April 8, sources said. One banking source told Reuters it was likely to be completed in the second quarter.
The bank said last November it had lost current account customers amid the negative publicity around its former chairman and its capital shortfall. But it said on Monday that core retail deposit balances had fallen by less that 1 percent to 27.9 billion pounds by the end of 2013, compared with a year before.
Co-op Bank had planned to buy 631 branches from state-backed Lloyds Banking Group last year, but the deal collapsed prior to its capital shortfall being exposed.
In written evidence to parliament's Treasury Select Committee published on Monday, former Bank of England Governor Mervyn King rejected a claim by Peter Levene, chairman of rival bidder NBNK, that he had been told by King that there was political interference in the bidding process for the branches.
In a letter to select committee Chairman Andrew Tyrie, King said he believed the government wished to ensure that a plausible bid from the Co-op be considered if possible but "that was a far cry from any improper conduct in the bidding process".
Co-op Bank said its objectives remained unchanged, namely to restore its capital position, focus on retail and small business customers and ditch non-core activities.
The bank had reduced its loan book by 2 billion pounds by the end of 2013 and cut its staff by 1,000 or 14 percent.
$1 = 0.6063 British Pounds Additional reporting by Kate Holton and Huw Jones; Editing by Mark Potter and David Holmes