Sept. 11 (Bloomberg) -- Lloyds Banking Group Plc, seeking to limit the U.K. Treasury’s stake, has yet to persuade the government that it has adequate capital and the ability to stick to lending commitments, say two people familiar with the matter.

Lloyds stock has climbed 17 percent in the past month as investors speculate the bank will cut the 260 billion pounds ($434 billion) of assets it’s paying the government to insure. Prime Minister Gordon Brown’s government took a 43 percent stake in exchange for a 17 billion-pound capital injection last year.

“There is now an expectation in the market that there will be a reduction in the use of the insurance program,” said Jonathan Newman, an analyst at Brewin Dolphin Securities Ltd. in London. “Now the prospects of some reduction have been raised, if it comes crashing down there will be some disappointment.”

London-based Lloyds sought a government rescue in the wake of Lehman Brothers Holdings Inc.’s collapse a year ago. Lloyds was crippled by its takeover of HBOS Plc and agreed to pay a fee of 15.6 billion pounds in March for state guarantees of losses from toxic assets. The Treasury took control of Royal Bank of Scotland Plc at about the same time.

In London today, Lloyd’s shares fell 0.2 percent to 105.01 pence after rising as much as 2.9 percent to 108.20 pence.

Lloyds needs to assure the government it is well capitalized, that it can pay the fee for the insurance and that it can honor a commitment to lend up to 28 billion pounds over two years, one of the people said.

Talks With Government

Negotiations are due to wrap up in the next few weeks, one of the people said. A spokesman for the Treasury, who declined to be named under department policy, said the discussions with Lloyds were taking place on the basis of an agreement in principle reached in March.

Lloyd’s and U.K. Financial Investments, charged with running the Treasury’s stakes in banks, declined to comment on the talks.

Lloyds is deciding whether to reduce the amount of toxic assets it insured under the government’s Asset Protection Scheme, three people familiar with the matter said separately this week. It is also in discussions with investors about selling new shares, they said.

Lloyds has submitted plans to the Financial Services Authority, which regulates banks, to raise capital and lower its involvement in the insurance program, one of the people said. It is also undergoing FSA stress tests, the person added.

Provisions ‘Peaked’

Lloyds last month posted a first-half loss of 3.1 billion pounds after setting aside 13.4 billion pounds to cover souring commercial and real estate loans, about 80 percent of which trace their roots to HBOS. The bank’s bad loan provisions have now “peaked,” Chief Executive Officer Eric Daniels said last month.

Under the Asset Protection Scheme, Lloyds will absorb the first 25 billion pounds of losses, with taxpayers liable for 90 percent of losses after that point. Taxpayers would hand over the fee in return for extra shares, increasing the government’s potential stake to 62 percent.

By raising as much as 6 billion pounds in a share sale, Lloyds would need to hand fewer shares to taxpayers, Jonathan Pierce, an analyst at Credit Suisse Group AG estimates. It may also cut by half the amount insured to 130 billion pounds as rising stock markets have effectively detoxified some assets.

Lloyds is also looking to reduce its dependence on the government because of concerns that the European Union may force it to sell branches and other assets in return for state aid. The commission in May forced Germany’s Commerzbank AG to sell assets to win approval for a rescue plan.

To contact the reporter on this story: Gonzalo Vina in London at gvina@bloomberg.net Andrew Macaskill in London at amacaskill@bloomberg.net

Last Updated: September 11, 2009 11:42 EDT