* IPO will create new independent challenger bank
* Lloyds had to sell business as condition of bailout
* TSB wants 6 percent market share in 4 to 5 years
* TSB won't pay dividend until 2017
(Adds comments from TSB Chief Executive)
LONDON, May 27 (Reuters) - Lloyds Banking Group expects to float about 25 percent of its TSB business on the London Stock Exchange next month, it said on Tuesday, kicking off a process regulators hope will create a vibrant challenger to Britain's dominant high-street lenders.
Lloyds was forced by European regulators to sell the 631 branches which now form TSB as a condition of receiving state aid during the financial crisis five years ago and it must therefore now sell the whole of TSB by the end of 2015.
However, the number of shares being sold in the initial offer is at the bottom end of expectations and banking industry sources said last week they expect them to be priced at less than TSB's book value of 1.5 billion pounds ($2.5 billion), meaning Lloyds will make a loss on the sale of the 200-year old brand.
That reflects a cooling of investor interest in UK company flotations in recent weeks following a rush of activity earlier in 2014. Clothing chain Fat Face pulled its planned London listing last week while holidays-to-insurance firm Saga priced its IPO at the bottom of its original range.
Lloyds had planned to sell the branches to the Co-operative Bank but that sale fell through last year when a 1.5 billion-pound funding gap at the Co-op emerged.
It subsequently revived the TSB brand, last seen on British high streets in the 1990s, with a view to a stockmarket sale.
Lawmakers and banking regulators are keen to see new banks emerge to break the dominance of Britain's biggest five lenders, which control more than three quarters of the personal current account market, and TSB is seen as a viable challenger.
The bank already has 4.5 million customers and 6 percent of bank branches in the UK, making it Britain's seventh-largest retail bank and giving it a headstart over other new entrants.
"We have the mindset and growth potential of a challenger but with the scale and capabilities of an established player," Chief Executive Paul Pester said on Tuesday.
However, TSB has only a 4.2 percent share of the personal current account market and Pester said it would take four to five years to reach its target of a 6 percent share.
Pester said TSB had picked up more customers than it lost since the brand was re-introduced to the high street last October.
"We are a net gainer from every major bank in the UK at present," he told reporters.
The share sale is expected to be completed by the end of June, with a prospectus due to be published in just over two weeks' time.
TSB is hoping to attract investors looking for exposure to Britain's economic recovery from a bank which is untainted by issues of past misconduct. The bank has agreed an indemnity from Lloyds against historical conduct-related losses meaning it will not need to pay out for past misconduct such as the mis-selling of loan insurance, which has cost Lloyds 9.8 billion pounds.
TSB's focus on growth means that it doesn't anticipate paying a dividend to shareholders until 2017 at the earliest, Pester said. The bank plans to expand its balance sheet by 40 to 50 percent over the next five years and is targeting a return on equity of 10 percent or over. On 31 March 2014 it had 23.3 billion pounds of deposits and 19.7 billion of assets.
The bank plans to attract retail shareholders with an offer of one free share for every 20 shares acquired in the initial public offer, up to a maximum investment of 2,000 pounds, provided they hold them for a year.
Pester said he expected between 15 and 20 percent of the shares will be sold to retail investors, rather than institutions such as pension funds and insurers.
JP Morgan and Citigroup are leading the IPO process. UBS is joint bookrunner ($10.5936 British Pounds)
(Additional reporting by Huw Jones; Editing by David Goodman and Greg Mahlich)