Part-nationalised British bank Lloyds said the sale of 632 retail bank branches to The Co-Operative Group was proving to be highly complex, signalling a deal may take longer than planned and could even fall apart.

Britain's regulator is taking a tough line and requiring the mutually owned conglomerate Co-Operative Group to strengthen its systems and board to prepare for the deal. Several analysts have warned it might have a hard task in taking on and integrating the Lloyds branches.

I think the Lloyds' statement is a warning shot to the Co-Op. It doesn't feel like a done deal, said Oriel Securities analyst Mike Trippitt.

Lloyds said on Thursday it was making progress in its talks with the Co-Operative over the deal, codenamed Project Verde.

However, given that this is a substantial business and a highly complex transaction, the group now anticipates providing a further update in Q2 2012, it added.

Lloyds said last year it had started exclusive talks to sell the branches to the Co-Op - a conglomerate whose businesses range from a retail supermarket division to financial services.

But it has always kept open the option of spinning off the assets and then listing them on the stock market, in case it could not pull off a sale, and one analyst said the chances of an initial public offering (IPO) had increased.

I think it's edging more towards an IPO. It doesn't surprise me that it's been held up, said Shore Capital analyst Gary Greenwood.

Lloyds reiterated on Thursday that while its preferred option remained a sale of the assets to the Co-Op, it would keep the fall-back option of an IPO.

It remains our preference to sell the Verde business to The Co-operative Group. In addition, the group is continuing to prepare for a divestment through an initial public offering, Lloyds said.

Co-Op also said it was making progress on the deal, but echoed Lloyds by noting the complexities of the transaction.

FSA WANTS REASSURANCES

Britain's Financial Services Authority (FSA) is expected to want reassurances that the Co-Op has strong enough capital, an experienced board and adequate systems and business plan before it gives a go-ahead for the deal.

In December, credit ratings agency Standard & Poor's cut its outlook on Co-Op due to the risks associated with the Lloyds deal.

Other analysts have said Co-Op may need to raise money through a debt issue to fund the acquisition, estimated to be worth some 1 billion pounds ($1.6 billion).

Lloyds, which is part-owned by the British government and last year announced plans to cut 15,000 jobs, said it would create around 500 new posts in the Verde business.

Co-Op beat off rival bidder NBNK - a new bank venture set up to acquire banking assets - in the Verde bid process last year.

Acquiring the Lloyds branches would mark a further expansion in Co-Op's banking business after it bought Britannia Building Society in 2009.

The sale of the Lloyds' Verde assets would create Britain's seventh-biggest bank, with the assets representing 4.6 percent of personal current or checking accounts and 5 percent of the mortgage market. They contributed about 500 million pounds of pretax profit in 2008 and income of about 1.4 billion.

Lloyds said it remained on track to complete the transfer of the bank branches before the end of 2013, in line with a timetable laid out for the sale by the European Commission.

European regulators ordered Lloyds to sell the assets as payback for getting a state bailout during the 2008 credit crisis, which left Britain with a 40 percent stake in the group.

A sale of the Verde retail branch assets would mark an important step towards Britain's longer-term plans of selling off its 40 percent Lloyds holding and its 82 percent stake in rival bailed-out lender Royal Bank of Scotland.

Lloyds shares closed down 1.7 percent at 35.25 pence - still well below the average 63 pence price at which the British taxpayer acquired its stake in the bank.

($1 = 0.6310 British pounds)

(Additional reporting by Steve Slater; Editing by Myles Neligan, Erica Billingham and Jane Merriman)