Feb. 26 (Bloomberg) -- Royal Bank of Scotland Group Plc will put 325 billion pounds ($462 billion) of investments into a state insurance program and shift toxic assets to a new unit after posting the biggest loss in British history.

Edinburgh-based RBS, the largest bank controlled by the U.K. government, plans to transfer 540 billion pounds of assets, including derivatives and loans on commercial and residential property, to the new division, mirroring the so-called bad bank created by Citigroup Inc. last month.

RBS and Lloyds Banking Group Plc rose more than 25 percent in London trading as the government provided a bigger guarantee than analysts had estimated. Prime Minister Gordon Brown’s government agreed to insure the distressed assets of British banks to boost capital, spur lending and jumpstart the economy, which is facing its worst recession since the 1980s.

“It draws a line under the problems of what we know is a very weakened business,” said Julian Chillingworth, chief investment officer at London-based Rathbone Brothers Plc, which manages $21 billion, including shares of RBS and Lloyds. “The asset protection scheme is more generous to the banking sector than was previously thought.”

In return for the insurance, RBS will pay a fee of 6.5 billion pounds over seven years in the form of preference shares. It will also increase lending to U.K. homeowners and businesses by 50 billion pounds over the next two years, the company said in a statement.

Treasury Investment

The Treasury will buy 13 billion pounds of RBS preference shares, which pay 7 percent interest, and may purchase an additional 6 billion pounds worth at the bank’s discretion.

Lloyds is in talks with the Treasury about participating in the insurance program. No terms have been agreed and there is no certainty Lloyds will receive the same terms as RBS, the London- based lender said in a statement.

“We’re going to rebuild confidence and provide certainty to enable banks to maintain and extend lending,” Chancellor Alistair Darling said in an interview today.

RBS rose 26 percent to 29 pence in London trading, with Lloyds gaining 31 percent to 75 pence. Barclays Plc advanced 7 percent to 113 pence.

Shares of RBS have declined 41 percent this year, compared with a 24 percent drop in the five-member FTSE 350 Banks Index, amid concerns the bank may be fully nationalized. In the past month two analysts rated the stock a “buy,” eight a “hold” and three a “sell,” according to data compiled by Bloomberg.

Government Investment

The government currently owns 58 percent of RBS. The state’s stake in voting shares may rise to 75 percent and the “economic interest” may jump to as much as 95 percent, Chief Executive Officer Stephen Hester said on a conference call with reporters.

RBS has already written down the value of the insured assets by 7.1 percent to 302 billion pounds. It will be responsible for the first 19.5 billion pounds of losses on that total, plus 10 percent of any additional drop. The Treasury will cover the rest, according to the statement.

The highest-rated bonds secured against corporate loans are currently worth 20 to 25 percent less than their face value on the secondary market, according to Deutsche Bank AG prices. Top- rated commercial property-backed bonds trade for as much as 40 percent less than face value, and top-rated bonds secured against prime U.K. mortgages are trading at a 7 percent discount. RBS didn’t say what credit ratings the insured assets had.

The prices of shops, offices and warehouses in the U.K. are 37 percent lower than their mid-2007 peak, according to the Investment Property Databank Ltd.

Government Liability

The government may be left liable for losses of more than 20 billion pounds as RBS places its most toxic assets in the program, said Sandy Chen, an analyst at Panmure Gordon & Co. in London who has a “sell” rating on the stock.

It “raises the question of whether or not the Treasury is fully aware of the potential losses that it (read: we taxpayers) might have to bear,” Chen said in a note to shareholders.

RBS’s new “non-core” division will hold 240 billion pounds of third-party assets, 145 billion pounds of derivative balances and 155 billion pounds of “risky assets” the bank will wind down or sell over three to five years, the lender said. The bank will “significantly” reduce its presence in or withdraw from 36 of the 54 countries in which it operates.

Risky assets will fall by 144 billion pounds, RBS said.

‘Measure of Stability’

RBS will reduce costs by 2.5 billion pounds and remove 45 percent of capital deployed in its global banking and markets securities unit, the bank said in a statement. Job loses of 20,000 are “not irresponsible speculation,” Hester said.

“The asset protection scheme will give us a measure of stability in a hostile economic environment,” he said. “The key building blocks for RBS’s recovery are in place. That doesn’t mean we will recover.”

RBS reported a net loss of 24.1 billion pounds, or 61 pence a share, compared with a profit of 7.3 billion pounds, or 75.7 pence, in the year-earlier period. The loss is the biggest ever reported by a U.K. company, surpassing the 22 billion pounds Vodafone Group Plc posted in 2006.

The median estimate of eight analysts surveyed by Bloomberg News was 25.9 billion pounds.

Citigroup announced plans last month to split in two after the New York-based bank reported a record 2008 loss of $18.7 billion. CEO Vikram Pandit, undoing the legacy of former chief Sanford “Sandy” Weill, created Citicorp to house the company’s global bank; and Citi Holdings, for “non-core” assets, including $301 billion of mortgages, bonds, corporate loans and other assets that the U.S. government agreed to guarantee.

Goodwin Pension

Hester is selling international assets to focus on U.K. lending after the bank was damaged by acquisitions, including former Chief Executive Officer Fred Goodwin’s 14.3 billion-euro ($19 billion) takeover of ABN Amro Holding NV’s investment- banking assets in 2007.

Goodwin was ousted in October after the government agreed to provide RBS with 20 billion pounds and take control the bank. Yesterday, the bank said it had sought legal advice on Goodwin’s 650,000-pound annual pension.

“RBS is taking further legal advice in respect of certain aspects of Sir Fred Goodwin’s contractual arrangements,” and continues to discuss the position with the U.K. Financial Investments Ltd., the agency that holds the government’s bank stakes, RBS spokesman Neil Moorhouse said.

To contact the reporter on this story: Jon Menon in London at jmenon1@bloomberg.net

Last Updated: February 26, 2009 11:53 EST