Sept. 4 (Bloomberg) -- Royal Bank of Scotland Group Plc, the largest bank bailed out by the U.K., said it won’t redeem $1.6 billion of subordinated bonds early after regulators objected to using state aid to pay off lower-rated notes.

The Financial Services Authority, the U.K.’s market regulator, told RBS not to exercise a so-called call option on four securities after the European Commission ruled Aug. 19 that banks shouldn’t use taxpayers’ money to repay equity and subordinated debt, the Edinburgh-based lender said in a statement today.

One of the four bonds, a 400 million-euro ($571 million) undated note, plunged 20 cents on the euro to 66.5 cents today, according to data compiled by Bloomberg. RBS is 70 percent owned by the U.K. government after receiving a 20 billion-pound ($33 billion) bailout last year and putting 325 billion pounds of assets into a state insurance program.

“Investors are learning their lessons the hard way,” said Jamie Stuttard, who manages about $18 billion as the London- based head of European and U.K. fixed income at Schroders Plc. “There are quite a few banks out there that are bust and rely on governments, and if you’re in a junior part of the capital you can’t make blind assumptions about getting paid.”

Neil Moorhouse, an RBS spokesman in Edinburgh, declined to comment beyond the statement.

Bonds at Stake

The European Commission is taking a tougher stance on how banks rescued with state cash repay investors in high-risk subordinated capital securities designed to absorb losses.

The executive arm of the European Union is insisting investors share with taxpayers the burden of rescuing banks, and already told Bayerische Landesbank, Germany’s second-largest state-owned lender and Dublin-based Anglo Irish Bank Corp. to defer payments on subordinated debt.

The Commission’s ruling may affect more than 8.7 billion euros of subordinated notes issued by banks that come under state-aid rules and which have call dates in 2009 and 2010, according to data compiled by Societe Generale SA analysts in London.

The cost of protecting RBS’s subordinated bonds using credit-default swaps rose today, with contracts climbing 19 basis points to 321, according to CMA DataVision. Default swaps tied to subordinated notes sold by Lloyds Banking Group Plc, whose predecessors were bailed out by the U.K. in October, increased 9 basis points to 297, CMA prices showed.

‘Impacts All Financials’

RBS’s decision not to call the subordinated notes “clearly impacts all financials where there is government involvement, most obviously Lloyds,” said Marc Ostwald, a strategist at Monument Securities Ltd. in London.

Lloyds is “working closely with” the U.K. “to demonstrate to the European Commission that the group has a strong plan to exit state aid,” London-based spokeswoman Leigh Calder wrote in an e-mailed response to questions.

Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements. A basis point on a contract protecting 10 million euros of debt from default for five years is equivalent to 1,000 euros a year.

As well as not calling junior notes, some European banks bailed out with state funds have skipped interest payments on the debt. Northern Rock Plc, the first lender nationalized by the U.K. in the credit crisis, said last month it would defer coupons on eight subordinated bonds with an aggregate face value of about $2.74 billion.

Jule Wilson, a spokeswoman for Northern Rock, said the bank took the decision in conjunction with the U.K. Treasury and that it wasn’t the result of pressure from European authorities.

State-Aid Discussions

Last month’s statement from the Commission “made it clear that banks subject to restructuring under state-aid rules should not use state aid to remunerate their own capital,” the FSA said in an e-mail today. Calling the notes “would adversely affect the ongoing state-aid discussions in relation to RBS,” the London-based regulator said.

The U.K. Treasury has committed 1.4 trillion pounds to rescue the nation’s banking system through direct investments, asset insurance and loan underwriting amid the worst recession in 60 years. Banks and insurance companies worldwide have lost or written down more than $1.6 trillion since 2007, according to data compiled by Bloomberg.

No. 1 Arranger

Under the leadership of former Chief Executive Officer Fred Goodwin, RBS was one of the biggest lenders of leveraged buyout loans to highly indebted companies acquired in mergers and acquisitions before the credit crunch bit. Goodwin, 51, became the target of criticism after walking away from the state- rescued bank with an annual pension of 555,000 pounds, which he later agreed to cut by 38 percent.

RBS was also hurt after taking over Amsterdam-based ABN Amro Holding NV, which left it saddled with bad debts and depleted cash reserves, leading to the biggest-ever loss reported by a U.K. company. RBS stock rose as much as 3.1 percent, and was up 1.3 percent at 55.70 pence as of 4:40 p.m. in London.

RBS said today that it won’t call the four notes at their early redemption dates in October. Two of the bonds, with a combined face value of 500 million euros, are so-called upper Tier 2 notes, while the other two, totaling A$1 billion ($840 million), are more-senior lower Tier 2 notes, RBS said.

“We’re going to see more examples of this,” said Simon Adamson, an analyst at the independent debt research firm CreditSights Inc. in London. “The interesting thing is that these are lower Tier 2 notes that are affected, meaning the Commission is extending its oversight to that part of banks’ capital base.”

To contact the reporter on this story: John Glover in London at johnglover@bloomberg.net

Last Updated: September 4, 2009 11:42 EDT