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UPDATE 3-UK watchdog under fire for lack of penalties in RBS small-business scandal

Iain Withers

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* FCA said its powers were limited in this case

* Senior lawmaker describes decision as a "whitewash"

* RBS says committed to ensuring mistakes cannot be repeated (Adds comments from MP Nicky Morgan)

LONDON, June 13 (Reuters) - Britain's financial watchdog has defended its decision not to penalise lender RBS or its former executives for past mistreatment of small business customers, drawing fire from senior lawmakers and victims' groups.

The Financial Conduct Authority (FCA) said it was sticking by its decision not to apply penalties for actions of RBS's former turnaround unit, the Global Restructuring Group (GRG).

"Our investigation has found that GRG clearly fell short of the high standards its clients expected, but it was largely unregulated and so our powers to take action in such circumstances, even where the mistreatment of customers has been identified and accepted, are very limited," FCA Chief Executive Andrew Bailey said in a statement on Thursday.

The FCA's decision was criticised by senior members of parliament and by small-business victims' groups.

Nicky Morgan, chair of parliament's Treasury committee, said the FCA needed to be given powers to properly regulate commercial lending and protect small firms.

This long overdue report will offer no solace to those who suffered from the disgraceful actions of RBS GRG," she said.

Fellow lawmaker Kevin Hollinrake, who is co-chair of parliament's all-party group for fair business banking, called the FCA's report "another complete whitewash" and said it demonstrated the regulator was failing to perform its role.

The SME Alliance campaign group, meanwhile, said it was "deeply disappointed" with the regulator's findings.

The mistreatment of businesses that were in financial distress and moved into GRG is one of the biggest scandals RBS has faced in recent years.

A previous FCA report had found that GRG was responsible for widespread mistreatment of business customers between 2008 and 2013 and blamed former bank bosses for pursuing profits at the expense of the health of some companies.

Last July's FCA decision not to apply penalties was widely criticised, with MP Nicky Morgan calling it "bewildering".

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On Thursday the watchdog repeated its view that it did not have the powers to take action and that external legal counsel had agreed with its conclusion.

The FCA said that stronger powers have since been introduced to give it greater ability to act in future cases, though it could not say whether it would have been able to bring a successful case under the new rules.

The report did not name individual managers involved, which the watchdog said would not be "legally justifiable".

The FCA said that, in coming to its conclusions, it had been "required" to take into account the "unprecedented stress" inflicted on RBS by failings of former management in the years leading up to the financial crisis.

RBS Chairman Howard Davies welcomed the conclusion of the investigation and confirmation that no further action will be taken.

The way the bank deals with business customers in financial difficulty today is fundamentally different to the aftermath of the financial crisis," he said.

"We are committed to ensuring that past mistakes cannot be repeated.

(Reporting by Iain Withers Editing by David Goodman and Elaine Hardcastle)