* State-backed RBS needs about 2 bln stg in additional capital
* Bank of England sees challenging outlook for financial system
* RBS shares fall as much as 4.6 percent
* Lender says will meet shortfall through cost cuts, asset sales
* Graphic: RBS's legal headaches tmsnrt.rs/2eV4Ihz (Adds further detail, BoE Governor quotes, shareholder reaction)
By Huw Jones and David Milliken
LONDON, Nov 30 (Reuters) - Royal Bank of Scotland (RBS) will cut costs and sell assets to boost capital, it said on Wednesday after failing its Bank of England stress test, with the central bank warning of a “challenging” outlook for Britain’s financial system.
State-backed RBS rushed out a statement after the test results to say it would take a range of actions to make up the capital shortfall identified, amounting to about 2 billion pounds ($2.49 billion).
Shares in RBS, which was bailed out by UK taxpayers eight years ago, fell 4.6 percent to 188 pence before reducing losses to 2.9 percent at 1139 GMT.
The unexpected result underlines the litany of problems with which RBS is grappling, including a mounting legal bill for misconduct before the 2008 financial crisis and difficulties selling off assets such as its Williams & Glyn banking business.
The Bank of England (BoE) approved RBS’s new capital plan on Tuesday night.
“Its challenge is that it still has legacy issues ... There’s misconduct costs, there’s impaired assets, they’re still working through the so-called non-core assets, on which they have made progress,” BoE Governor Mark Carney told reporters on Wednesday.
“They are not talking about raising capital. The magnitude of their plan is much bigger than the size of the shortfall in the stress test.”
RBS, which is expected to settle soon with U.S. authorities over alleged mis-selling of mortgage backed securities in the run-up to the financial crisis, said the measures approved by the BoE should mean that it does not have to tap markets to cover the capital shortfall.
The bank is unlikely to have to sell any major assets and will instead raise the additional capital by reducing exposures in sectors including commercial property, oil and gas, a source at RBS said.
Asset sales would avoid the embarrassment of a rights issue, that would force the government to put in even more taxpayer money, given that it owns the majority of the shares.
RBS is expected to unveil a new cost-cutting plan at its full-year results in early 2017, which the source at the bank said is likely to include job cuts and branch closures, and analysts said the stress-test result would further delay RBS’s ability to pay dividends.
“It is going to be very difficult. They have been doing this for a while,” said Julian Chillingworth, Chief Investment Officer at Rathbone Brothers, an RBS shareholder.
Chillingworth remains confident in RBS Chief Executive Ross McEwan, describing him as “on the case”. Chillingworth said that the biggest worry would be if McEwan were to quit “because this is as much a political job as it is a banking job”.
Barclays also fell short by some measures in its stress test but will not have to submit a new capital-raising plan because it has already announced steps to strengthen its defences, including the planned sale of its African business, the BoE Financial Policy Committee (FPC) said.
Standard Chartered missed the test’s minimum Tier 1 capital target but also escapes the need for new capital-raising because of steps already taken to cut costs and sell assets.
The performance of the seven lenders tested was worse than many market participants had expected.
“This is the highest average fall in CET1 (a measure of capital) and leverage ratios we’ve seen in the history of a UK concurrent stress test,” said Steven Hall, banking partner at KPMG.
This year’s health check, the third by the Bank of England since the 2007-09 financial crisis forced taxpayers to bail out lenders such as RBS, was the toughest yet. Test scenarios combined shocks to both global and domestic economies, as well as the impact of potential misconduct fines.
Britain’s banking system underwent a severe real-life test in June, when markets and sterling plummeted in response to Britain’s vote to leave the European Union, and the Bank of England said on Wednesday that Britain’s financial system faces elevated Brexit risks and market volatility after the U.S. election.
HSBC, Lloyds Banking Group, Nationwide and Santander UK did not reveal any capital inadequacies in the test, the central bank said, adding that the level of capital in the UK banking system was satisfactory overall at 13.5 percent of risk-weighted assets.
The Bank of England also gave more detail on a second stress test that will be introduced next year alongside its annual check, saying that it will cover a seven-year period -- compared with five in the basic test -- and look at “severe headwinds” challenging profitability.
Banks could be required to change business models to make them more sustainable in the face of prolonged low interest rates and uncertainty over Britain’s future relations with the EU after it leaves the bloc.
The Bank of England is now developing a system-wide test to assess the dynamics of broader markets under stress and will conduct an in-depth assessment of risks from derivatives trades.
The FPC also published on Wednesday an assessment of insurers’ investment activities, concluding that changes are needed to the EU’s Solvency II insurance rules. ($1 = 0.8018 pounds)
Additional reporting by Lawrence White, Andrew MacAskill and Simon Jessop; Editing by Rachel Armstrong and David Goodman